[Senate Hearing 111-671, Volume 1]
[From the U.S. Government Publishing Office]




                                                       S. Hrg. 111-671
 
                 WALL STREET AND THE FINANCIAL CRISIS:
                    THE ROLE OF HIGH RISK HOME LOANS

=======================================================================

                                HEARING

                               before the

                PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                                 of the

                              COMMITTEE ON
                         HOMELAND SECURITY AND
                          GOVERNMENTAL AFFAIRS
                          UNITED STATES SENATE


                     ONE HUNDRED ELEVENTH CONGRESS

                             SECOND SESSION

                               ----------                              

                             VOLUME 1 OF 5

                               ----------                              

                             APRIL 13, 2010

                               ----------                              

       Available via http://www.gpoaccess.gov/congress/index.html

       Printed for the use of the Committee on Homeland Security
                        and Governmental Affairs

 WALL STREET AND THE FINANCIAL CRISIS: THE ROLE OF HIGH RISK HOME LOANS

                             VOLUME 1 OF 5




                                                        S. Hrg. 111-671

                 WALL STREET AND THE FINANCIAL CRISIS:
                    THE ROLE OF HIGH RISK HOME LOANS

=======================================================================

                                HEARING

                               before the

                PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                                 of the

                              COMMITTEE ON
                         HOMELAND SECURITY AND
                          GOVERNMENTAL AFFAIRS
                          UNITED STATES SENATE


                     ONE HUNDRED ELEVENTH CONGRESS

                             SECOND SESSION

                               __________

                             VOLUME 1 OF 5

                               __________

                             APRIL 13, 2010

                               __________

       Available via http://www.gpoaccess.gov/congress/index.html

       Printed for the use of the Committee on Homeland Security
                        and Governmental Affairs



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        COMMITTEE ON HOMELAND SECURITY AND GOVERNMENTAL AFFAIRS

               JOSEPH I. LIEBERMAN, Connecticut, Chairman
CARL LEVIN, Michigan                 SUSAN M. COLLINS, Maine
DANIEL K. AKAKA, Hawaii              TOM COBURN, Oklahoma
THOMAS R. CARPER, Delaware           JOHN McCAIN, Arizona
MARK L. PRYOR, Arkansas              GEORGE V. VOINOVICH, Ohio
MARY L. LANDRIEU, Louisiana          JOHN ENSIGN, Nevada
CLAIRE McCASKILL, Missouri           LINDSEY GRAHAM, South Carolina
JON TESTER, Montana                  ROBERT F. BENNETT, Utah
ROLAND W. BURRIS, Illinois
PAUL G. KIRK, JR., Massachusetts

                  Michael L. Alexander, Staff Director
     Brandon L. Milhorn, Minority Staff Director and Chief Counsel
                  Trina Driessnack Tyrer, Chief Clerk
         Patricia R. Hogan, Publications Clerk and GPO Detailee


                PERMANENT SUBCOMMITTEE ON INVESTIGATIONS

                     CARL LEVIN, Michigan, Chairman
THOMAS R. CARPER, Delaware           TOM COBURN, Oklahoma
MARK L. PRYOR, Arkansas              SUSAN M. COLLINS, Maine
CLAIRE McCASKILL, Missouri           JOHN McCAIN, Arizona
JON TESTER, Montana                  JOHN ENSIGN, Nevada
PAUL G. KIRK, JR., Massachusetts
            Elise J. Bean, Staff Director and Chief Counsel
                       Zachary I. Schram, Counsel
                     Nina E. Horowitz, GAO Detailee
            Christopher J. Barkley, Minority Staff Director
               Anthony G. Cotto, Counsel to the Minority
                     Mary D. Robertson, Chief Clerk


                            C O N T E N T S

                                 ------                                
Opening statements:
                                                                   Page
    Senator Levin................................................     1
    Senator Coburn...............................................    12
Prepared statements:
    Senator Levin................................................   119
    Senator Coburn...............................................   130
    Senator Collins..............................................   132

                               WITNESSES
                        Tuesday, April 13, 2010

James G. Vanasek, Former Chief Credit Officer (1999-2004) and 
  Chief Risk Officer (2004-2005), Washington Mutual Bank.........    14
Ronald J. Cathcart, Former Chief Enterprise Risk Officer (2006-
  2008), Washington Mutual Bank..................................    18
Randy Melby, Former General Auditor, Washington Mutual Bank......    20
David Schneider, Former President of Home Loans, Washington 
  Mutual Bank....................................................    51
David Beck, Former Division Head of Capital Markets, Washington 
  Mutual Bank....................................................    53
Stephen J. Rotella, Former President and Chief Operating Officer, 
  Washington Mutual Bank.........................................    83
Kerry K. Killinger, Former President, Chief Executive Officer, 
  and Chairman of the Board, Washington Mutual Bank..............    85

                     Alphabetical List of Witnesses

Beck, David:
    Testimony....................................................    53
    Prepared statement...........................................   163
Cathcart, Ronald J.:
    Testimony....................................................    18
    Prepared statement...........................................   138
Killinger, Kerry K.:.............................................
    Testimony....................................................    85
    Prepared statement with attachments..........................   179
Melby, Randy:
    Testimony....................................................    20
    Prepared statement...........................................   146
Rotella, Stephen J.:
    Testimony....................................................    83
    Prepared statement...........................................   169
Schneider, David:
    Testimony....................................................    51
    Prepared statement...........................................   158
Vanasek, James G.:
    Testimony....................................................    14
    Prepared statement...........................................   134

                              EXHIBIT LIST

* Retained in the files of the Subcommittee

 1.a. Memorandum from Permanent Subcommittee on Investigations 
  Chairman Carl Levin and Ranking Minority Member Tom Coburn to 
  the Members of the Subcommittee................................   207

   b. Washington Mutual Practices That Created A Mortgage Time 
  Bomb, chart prepared by the Permanent Subcommittee on 
  Investigations.................................................   213

   c. Securitizations of Washington Mutual and Long Beach 
  Subprime Home Loans, chart prepared by the Permanent 
  Subcommittee on Investigations.................................   214

   d. Excerpts from Documents Related to Washington Mutual's 
  Subprime Lender: Long Beach Mortgage Corporation (``LBMC'') 
  Lending and Securitization Deficiencies, chart prepared by the 
  Permanent Subcommittee on Investigations.......................   215

   e. Excerpts from Documents Related to Washington Mutual's 
  Prime Home Loan Lending and Securitization Deficiencies, chart 
  prepared by the Permanent Subcommittee on Investigations.......   217

   f. Excerpts from Documents Related to Washington Mutual 
  Compensation and Incentives, chart prepared by the Permanent 
  Subcommittee on Investigations.................................   219

   g. Select Delinquency and Loss Data for Washington Mutual 
  Securitizations, as of February 2010, chart prepared by the 
  Permanent Subcommittee on Investigations.......................   221

   h. Washington Mutual CEO Kerry Killinger: $100 Million In 
  Compensation, 2003-2008, chart prepared by the Permanent 
  Subcommittee on Investigations.................................   222

   i. WaMu Product Originations and Purchases By Percentage--
  2003-2007, chart prepared by the Permanent Subcommittee on 
  Investigations.................................................   223

   j. Estimation of Housing Bubble: Comparison of Recent 
  Appreciation vs. Historical Trends, chart prepared by Paulson & 
  Co, Inc........................................................   224

   k. Washington Mutual Organizational Chart, prepared by 
  Washington Mutual, taken from Home Loans 2007 Plan, Kick Off, 
  Seattle, August 4, 2006........................................   225

   l. Excerpts from Documents Related to Washington Mutual 
  Securitization of Delinquency-Prone Loans, First Quarter of 
  2007, chart prepared by the Permanent Subcommittee on 
  Investigations.................................................   226

   m. WaMu Originations and Purchases by Loan Type 2003-2007, 
  chart prepared by the Permanent Subcommittee on Investigations.   228

Documents Related to Higher Risk Lending Strategy:

 2.a. Washington Mutual, Higher Risk Lending Strategy, ``Asset 
  Allocation Initiative,'' Board of Directors, Finance Committee 
  Discussion, January 2005.......................................   229

   b. Washington Mutual, Asset Allocation Initiative: Higher 
  Risk Lending Strategy and Increased Credit Risk Management, 
  Board of Director Discussion, December 21, 2004................   248

   c. Washington Mutual, Higher Risk Lending Strategy, And 
  Increased Credit Risk Management, Board of Director Discussion, 
  January, 2005..................................................   262

 3. Washington Mutual, Home Loans Discussion, Board of Directors 
  Meeting, April 18, 2006 (excerpts).............................   278

 4. WaMu Presentation, Be Bold!, prepared by David Schneider, 
  Home Loans President (We Are ALL in Sales).....................   290

 5. Washington Mutual, Subprime Mortgage Program, January 2007 
  (excerpts).....................................................   295

 6.a. Washington Mutual Chairman and CEO Kerry Killinger 
  Memorandum to the Board of Directors, dated June 2007, re: WaMu 
  Strategic Direction............................................   332

   b. Washington Mutual, Home Loans--2007 Strategy Team Goals, 
  Updated 11/12/2007.............................................   342

   c. Washington Mutual Chairman and CEO Kerry Killinger 
  Memorandum to the Board of Directors, dated June 2005, re: 
  Strategic Direction............................................   343

   d. Washington Mutual Chairman and CEO Kerry Killinger 
  Memorandum to the Board of Directors, dated June 2006, re: 
  Strategic Direction............................................   357

   e. Washington Mutual Chairman and CEO Kerry Killinger 
  Memorandum to the Board of Directors, dated June 2008, re: WaMu 
  Strategic Direction............................................   370

 7. Management Presentation, WaMu Home Loans (excerpts).........   383

Documents Related to Long Beach:

 8.a. OTS internal email, dated April 2005, re: Fitch--LBMC 
  Review ([Securitizations] prior to 2003 have horrible 
  performance. LBMC finished in the top 12 worst annualized [net 
  credit losses] in 1997 and 1999 thru 2003. . . . At 2/05, LMBC 
  was #1 with a 12% delinquency rate. Industry was around 8.25%.)   388

   b. FDIC/Washington State Joint Visitation Report of 
  Washington Mutual Bank, dated January 13, 2004 (It concluded 
  that 40% (109 of 271) of loans reviewed were considered 
  unacceptable due to one or more critical errors. This raised 
  concerns over LBMC's ability to meet the representations and 
  warranty's made to facilitate sales of loan securitizations, 
  and management halted securitization activity.)................   389

 9. Washington Mutual, LBMC Post Mortem--Early Findings Read 
  Out, November 1, 2005 (First Payment Defaults (FPD's) are 
  preventable and/or detectable in nearly all cases (99%) . . . 
  High incident rate of potential fraud among FPD cases).........   395

10. Washington Mutual Memorandum to the Washington Mutual, Inc. 
  and WaMu Board of Directors' Audit Committees, dated April 17, 
  2006, re: Long Beach Mortgage Company--Repurchase Reserve Root 
  Cause Analysis . . . LBMC experienced a dramatic increase in 
  EPD's, during the third quarter of 2005. . . . [R]elaxed credit 
  guidelines, breakdowns in manual underwriting processes, and 
  inexperienced subprime personnel. . . . coupled with a push to 
  increase loan volume and the lack of an automated fraud 
  monitoring tool, exacerbated the deterioration in loan 
  quality.)......................................................   408

11. WaMu internal email, dated April 2006, re: Jax 
  ([D]elinquencies are up 140% and foreclosures close to 70%. . . 
  . It is ugly.).................................................   414

12. WaMu internal email, dated September 2006, re: nat city mid-
  quarter update (LBMC is terrible . . . [W]e are cleaning up a 
  mess. Repurchases, EPDs, manual underwriting, very weak 
  servicing/collections practices and a weak staff.).............   415

13.a. WaMu internal email, dated December 2006, re: SubPrime 
  Analysis (Short story is this is not good. . . . [L]arge 
  potential risk from what appears to be a recent increase in 
  repurchase requests. . . . We are all rapidly losing 
  credibility as a management team.).............................   418

   b. FDIC Memorandum, dated June 5, 2007, re: WaMu-Long Beach 
  Mortgage Company (LMBC) Repurchases............................   422

14. WaMu, Home Loans--SubPrime, Quarterly Credit Risk Review, 
  December 2006 (excerpts).......................................   427

15. WaMu internal email, dated December 2006, re: It's suprime 
  day at WSJ (attaching Wall Street Journal articles on 
  subprime)(. . . our 2006 Long Beach securities have much higher 
  delinquency rates early in their life than the 2003 and 2005 
  vintages.).....................................................   443

16. WaMu internal email, dated January 2007, re: Confidential 
  (Long Beach represents a real problem for WaMu.)...............   448

17. WaMu internal email, dated February 2007, re: Long Beach 2nd 
  Lien Disposition (In 2006 Beck's team started sprinkling 
  seconds in deals as they could.)...............................   450

18. WaMu, HL Risk Management, Quarterly Credit Risk Review, 
  SubPrime, 1st Quarter, 2007 (The root cause of over 70% of FPDs 
  involved operational issues such as missed fraud flags, 
  underwriting errors, and condition clearing errors.) (excerpts)   453

19. WaMu, Audit Report, Long Beach Mortgage Loan Origination & 
  Underwriting, August 20, 2007 ([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.).................   462

20. WaMu internal email, dated August 2007, re: Long Beach 
  Mortgage Loan Origination & Underwriting (Requires 
  Improvement)(This seems to me to be the ultimate in bayonetting 
  the wounded, if not the dead.).................................   475

21. WaMu Corporate Credit Review, Home Loans, Wholesale 
  Specialty Lending-FPD, 2007 Targeted Review (132 of the 187 
  (71%) files were reviewed [and] . . . confirmed fraud on 115 
  [and 17 were] . . . ``highly suspect''. . . . 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 . . .)..........................   477

Documents Related to WaMu Retail Channel:

22.a. WaMu internal memorandum, dated November 2005, re: So. CA 
  Emerging Markets Targeted Loan Review Results (Of the 129 
  detailed loan reviewed that have been 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...............   496

   b. WaMu Retail Fraud Risk Overview, Prepared by Risk 
  Mitigation, November 16, 2005..................................   497

23.a. WaMu internal email chain, dated November 2005: re: Retail 
  Fraud Risk Overview (I had a very quick meeting with David 
  Schneider, Tony Meola and Steve Stein today to review the deck 
  and the memo regarding the retail fraud risk review. The good 
  news is that people are taking this very seriously.)...........   509

   b. WaMu internal email chain, dated August 2005, re: [names 
  redacted]--Risk Mit Loan review data ``Confidential'' (. . . he 
  ``did not want to give axes to the murderers.'')...............   511

24. WaMu Privileged and Confidential Memorandum, dated April 
  2008, re: Memorandum of Results: AIG/UG and OTS Allegation of 
  Loan Frauds Originated by [name redacted]......................   515

25. Office of Thrift Supervision Memorandum, dated June 19, 
  2008, re: Loan Fraud Investigation.............................   527

26. WaMu OTS Exam Summary As of July 22, 2008 (OTS AQ #22 Loan 
  Fraud Investigation.) (excerpts)...............................   530

27. WaMu internal email chain, dated August 2006, re: Hudson 
  3010598427 Purchase (Sales has NOT hit oiur [sic] funding 
  goals.)........................................................   532

28. WaMu Market Risk Committee (MRC), Minutes of the December 
  12, 2006 Meeting (The primary factors contributing to increased 
  delinquency appear to be caused by process issues including the 
  sale and securitization of delinquent loans, loans not 
  underwritten to standards, lower credit quality loans and 
  seller servicers reporting false delinquent payment status.)...   537

29. WaMu internal Memorandum, dated September 2007, re: Westlake 
  HLC Investigation Update.......................................   542

30. WaMu Significant Incident Notification (SIN), Date Incident 
  Reported--04/01/2008, Loss Type--Mortgage Loan (One Sales 
  Associate admitted that during that crunch time some of the 
  Associates would ``manufacture'' assets statements from 
  previous loan docs and submit them to the LFC. She said the 
  pressure was tremendous from the LFC to get them the docs since 
  the loan had already funded and pressure from the Loan 
  Consultants to get the loans funded.)..........................   544

31. WaMu Internal Investigative Report, dated May 2008, re: 
  Westlake Home Loan Center (. . . tremendous pressure from the 
  Loan Consultants and from the LFC Team Manager to get the asset 
  documents to the LFC because the loan was already funded.).....   546

32.a. WaMu internal email chain, dated December 2007, re: 
  Employee HELOC Fraud (. . . 75 suspect HELOC loans have been 
  identified (approved & in pipeline) . . . with a current 
  outstanding balance of $3,318,101.)............................   548

   b. WaMu Significant Incident Notification (SIN), Date 
  Incident Reported--05/01/2008, Loss Type--HELOC Fraud (Risk 
  Mitigation reviewed 25 HELOC loans . . . with a total exposure 
  of $8,538,600.00.).............................................   552

33. Radian Guaranty Inc. Review of Washington Mutual Bank, 
  August-September 2007 (This results in an overall 
  ``Unacceptable'' rating with a score of 68.) (excerpts)........   553

34. WaMu Corporate Credit Review, 2008 Home Loans, Risk 
  Mitigation and Mortgage Fraud, 2008 Targeted Review (excerpts).   564

Documents Related to Option Arms:

35. Washington Mutual, Option ARM Focus Groups--Phase II, WaMu 
  Option ARM Customers, September 17, 2003.......................   569

36. Washington Mutual, Option ARM Focus Groups--Phase I, WaMu 
  Loan Consultants and Mortgage Brokers, August 14, 2003 
  (excerpts).....................................................   581

37. Washington Mutual, Option ARM Credit Risk, August 2006.......   591

38. Washington Mutual, Option ARM, Board of Directors Meeting, 
  October 17, 2006...............................................   620

39. WaMu internal email, dated April 2007, re: Option ARM's (I 
  think we better be well prepared to defend the option ARM 
  portfolio.)....................................................   628

40.a. WaMu internal email, dated September 2006, re: Tom Casey 
  visit (. . . equity investors are totally freaking about 
  housing now.)..................................................   630

   b. WaMu internal email, dated February 2007, re: Option ARM 
  MTA and Option ARM MTA Delinquency (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.)................................................   632

41. WaMu internal email, dated February 2007, re: Some thoughts 
  on targeted population for potential Option ARM MTA loan 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.).................................................   636

42.a. WaMu internal email, dated February 2007, re: HFI 
  selection criteria changes (Effective March 7, 2007, modify the 
  portfolio opion ARM and COFI ARM retention criteria . . . to 
  include only following loans for the portfolio (HFI). . . . As 
  a result of this change, we expected to securitize and settle 
  about $2 billion more option/COFI ARMs in Q1-07. . . . 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.)..............................................   637

   b. WaMu internal email, dated February 2007, re: HFI Option 
  Arms redirected to HFS (That amounts to roughly 3B option arms 
  available for sale. I would like to get these loans into HFS 
  immediately so that I can sell as many as possible in Q1.).....   638

43. WaMu Market Risk Committee (MRC), Minutes of March 9, 2007 
  Meeting (. . . 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).)......................   641

44. WaMu Market Risk Committee Minutes, July 11, 2008 (NPA HFI 
  HELOC Loan Sales. . . . it is in our best interest to let some 
  one else assume the risk of these loans.) (excerpts)...........   645

Documents Related to Securitization:

45. WaMu Wholesale Speciality Lending, Securitization 
  Performance Summary, June 2008 ($77 billion in subprime 
  securitizations listed)........................................   647

46. Washington Mutual Mortgage Securities Corp., Securitization 
  Performance Summary, June 2008 Distribution. ($196 billion in 
  prime securitizations listed)..................................   648

47.a. Two diagrams of a Long Beach mortgage backed security, 
  attached to a FDIC Memorandum, dated May 15, 2006, re: WaMu 
  Mortgage Securitizations.......................................   651

   b. List of WaMu-Goldman Loans Sales and Securitizations......   653

   c. WaMu PowerPoint presentation by David Beck, Executive Vice 
  President, WaMu Capital Markets, June 11, 2007 (excerpts)......   656

48. WaMu Wholesale Specialty Lending, Bond Rating Changes, As of 
  June 2008 Distribution (excerpts)..............................   662

49. WaMu internal email, dated August 2004, re: Interesting 
  Friedman Billings piece re: Mortgage Brokers (Which Product 
  Should Capital Markets Being Pushing?).........................   665

50. WaMu internal email, dated November 2006, re: Goldman Sachs 
  New Issue Home Eq Commentary (External) (LBMC paper is among 
  the worst performing paper in the mkt in 2006.)................   670

51. WaMu internal email, dated February 2008, re: Screen shot 
  (Attaching copy of Evidence of ``Walking Away'' In WaMu 
  Mortgage Pool, February 23, 2008, Mish's Global Economic Trend 
  Analysis.......................................................   673

52. WaMu internal email, dated March 2007, re: our discussion 
  yesterday and what the street perception will be (WaMu subprime 
  ABS delinquencies top ABX components)..........................   679

53. WaMu Leads in Risky Type of Lending--Analysis Shows Thrift 
  Makes Frequent Loans for Investment Homes, April 17, 2007, Wall 
  Street Journal.................................................   680

54.a./b./c.: WaMu/Goldman Sachs email chains, dated March, May, 
  and July 2007, regarding repurchase issues............. 682, 684, 688

55. WaMu internal email, dated August 2007, re: Scenarios (From 
  today's meeting, I understand that we don't have the courage to 
  evaluate this scenario.).......................................   691

56. WaMu internal email, dated May 2008, re: WSJ on 
  repurchases--likely will lead to some IR questions although we 
  are not mentioned (7 Step process).............................   692

57. WaMu internal email, dated June 2008, re: Repurchase 
  Recommendations W/E 6/20/08 (The actual loans we do buy back 
  are real stinkers.)............................................   697

58. Worst Ten in the Worst Ten, document prepared by the Office 
  of the Comptroller of the Currency (OCC), 11/13/08 (The table 
  below sets forth the ten metropolitan areas experiencing the 
  highest rates of foreclosure as reported by Realty Trac (the 
  ``Worst Ten'' MSAs). . . . Long Beach Mortgage Co. . . . 
  11,736.).......................................................   698

Documents Related to Compensation:

59.a./b. Documents regarding Long Beach compensation, 2004 
  (excerpts) and 2007........................................  701, 708

60.a. WaMu, Home Loans, 2007 Product Strategy, Strategy and 
  Business Initiatives Update (Retail Loan Consultant 2007 
  Incentive Plan Focus on High Margin Products) (excerpts).......   711

   b. Washington Mutual, Home Loan Credit Risk F2F, December 6, 
  2006 (Internal Forces . . . Overages; Internal Forces . . . 
  Overage Proposal). (excerpts)..................................   722
   c. Excerpt from Washington Mutual Lender's Addendum to 
  Closing Instructions, September 2007 (showing inclusion of 
  Yield Spread Premium in compensation of third part mortgage 
  broker)........................................................   725

61. Long Beach processing center internal email, dated September 
  2004, re: Daily Productivity--Dublin (. . . it's time for the 
  mad dash to the finish line!)..................................   726

62. Washington Mutual--Home Loans flyer, dated November 2006, 
  President's Club--Take the Lead!...............................   727

63.a. Washington Mutual, Home Loans Group, President's Club 
  2005--Maui, Awards Night Show Script (excerpts)................   728

   b. Washington Mutual, Home Loans Group, President's Club 
  2006, Funeral Skit related to Countrywide......................   745

   c. WaMu, Home Loans Group, President's Club 2006, ``I Like 
  Big Bucks'' Skit...............................................   748

   d. SEALED EXHIBIT: Washington Mutual, Home Loans Group, 
  President's Club 2005--Maui, Awards Night Show Script. 
  (Unredacted version of Exhibit 63a.)...........................    * 
64. Cheryl Feltgen 2007 Performance Review (Growth 35%).........   750

65. WaMu internal email, dated January 2008, re: comp (But we 
  have to convince our folks that they will all make a lot of 
  money by being with WaMu.).....................................   751

66. WaMu internal email, dated July 2008, re: Comp (We would 
  like to have the HR committee approve excluding the exec com 
  from the 2008 bonus and to approve the cash retention grants to 
  the non NEOs. 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 members.)........................   754

67. WaMu internal email, dated March 2008, re: WaMu Board 
  Shields Executives' Bonuses--WSJ Article (March 5, 2008).......   755

68. WaMu creditors could challenge payments to Killinger, 
  others, The Seattle Times, October 1, 2008.....................   757

Documents Related to Various Issues:

69.a. WaMu internal email, dated October 2007, re: Can you take 
  a look at this before Monday and give your blessing? (I don't 
  trust Goldy on this. They are smart, but this is swimming with 
  the sharks. They were shorting mortgages big time while they 
  were giving CfC advice.).......................................   759

   b. WaMu/Goldman email chain, dated February 2007, re: Request 
  to Talk (. . . Goldman and Long Beach/WaMu have had a long 
  standing and successful relationship for years.)...............   761

70. WaMu internal email, dated May 2005, re: Strategic Planning 
  Meeting (The avalanche of publicity on interest only, home 
  equity, neg am and sub-prime expansion that has occurred in 
  just the last three or four weeks is amazing.).................   764

71. WaMu internal email, dated March 2006, re: Organizational 
  Changes in Enterprise Risk Management..........................   766

72. Washington Mutual Internal Memorandum, dated October 2006, 
  re: State of ERM: Effectiveness and Resource Adequacy Overview.   769

73. WaMu internal email, dated January 2007, re: Year-End 2006 
  Message for the Home Loans Risk Management Team (Recognize that 
  ``we are all in sales'' passionately focused on delivering 
  great products and service to our customers.)..................   775

74. WaMu internal email, dated February 2008, re: Credit Cost 
  Forecast (Un)reliability (. . . I would add poor underwriting 
  quality which in some cases causes our origination data to be 
  suspect. . . .)................................................   778

75. WaMu internal email, dated February 2008, re: 4pm 10K Audit 
  Committee Meeting (I would suggest using the word ``majority'' 
  and deleting the word ``significantly''. . . .)................   780

76. WaMu internal email, dated March 2007, re: Draft Subprime 
  Mortgage Guidance--Draft WaMu Position (Based on Today's 
  conversation, I don't see a need to do anything now.)..........   784

77. WaMu internal email, dated March 2007, re: Follow-up 
  information to last evening's call regarding subprime 
  interagency guidance, etc. . . . (If we implement the NTM 
  changes to all loans, then we'll see additional drop of 33% of 
  volume.).......................................................   787

78.a. WaMu internal email chain, dated March 2005, re: Updates 
  (I 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.)...........................................   790

   b. WaMu memorandum, dated September 2004, re: Perspective (If 
  the economy stalls, the combination of low FICOs, high LTVs and 
  inordinate levels of exceptions will come back to haunt us.)...   792

79. WaMu internal email, dated August 2007, re: Looking back 
  (Your fingers must be smoking.)................................   793

80. WaMu, July 2008, Home Loans Story, External & Internal Views   797

81. WaMu internal email, dated February 2007, re: Long Beach 2nd 
  Lien Disposition (. . . how best to dispose of 433MM of 
  performing 2nd lien loans in the Long Beach warehouse.)........   810

82. Long Beach Mortgage Loan Coordinator Convicted of Lying to 
  Grand Jury In Connection With Mortgage Fraud Investigation, 
  Department of Justice News Release, December 17, 2007..........   814

83. Subprime Lending: A Net Drain on Homeownership, Center for 
  Responsible Lending Issue Paper No. 14, March 27, 2007.........   816

84. Long Beach Mortgage Loan Purchase Agreement, January 2006...   821

85. GWashington Mutual Bank Mortgage Loan Purchase and Sale 
  Agreement, October 2005........................................   856

86. WaMu Prospectus Supplements (excerpts):
   a. WaMu Series 2007-OA3......................................   894

   b. WMALT Series 2007-OA3.....................................   897

   c. WaMu Series 2007-OA4......................................   900

   d. WMALT Series 2007-OA4.....................................   903

87. Responses to supplemental questions for the record submitted 
  by Senator John Ensign to Kerry Killinger, Former President, 
  CEO, and Chairman of the Board, Washington Mutual Bank.........   907

88. Responses to supplemental questions for the record submitted 
  by Senator John Ensign to Stephen Rotella, Former President and 
  Chief Operating Officer, Washington Mutual Bank................   913

89. SEALED EXHIBIT: Response to supplemental questions for the 
  record submitted by Senators Carl Levin and Tom Coburn 
  regarding the potential sale of Washington Mutual Bank 
  submitted to Kerry Killinger, Former President, CEO, and 
  Chairman of the Board, Washington Mutual Bank..................    * 

90. Washington Mutual, Fannie Mae Alliance and Freddie Mac 
  Business Relationship Proposal.................................   920

* Retained in the files of the Subcommittee


 WALL STREET AND THE FINANCIAL CRISIS: THE ROLE OF HIGH-RISK HOME LOANS

                              ----------                              


                        TUESDAY, APRIL 13, 2010

                                   U.S. Senate,    
              Permanent Subcommittee on Investigations,    
                    of the Committee on Homeland Security  
                                  and Governmental Affairs,
                                                    Washington, DC.
    The Subcommittee met, pursuant to notice, at 9:33 a.m., in 
room SD-342, Dirksen Senate Office Building, Hon. Carl Levin, 
Chairman of the Subcommittee, presiding.
    Present: Senators Levin, Kaufman, Coburn, Collins, and 
Ensign.
    Staff Present: Elise J. Bean, Staff Director/Chief Counsel; 
Zachary I. Schram, Counsel; Mary D. Robertson, Chief Clerk; 
David H. Katz, Counsel; Allison F. Murphy, Counsel; Adam 
Henderson, Professional Staff Member; Jason E. Medica, Detailee 
(ICE); Christopher Barkley, Staff Director to the Minority; 
Anthony G. Cotto, Counsel to the Minority; Robert Kaplan, 
Intern; Jeff Kruszewski, Law Clerk; Ryan McCord, Law Clerk; 
Kevin Rosenbaum, Intern; Andrew Tyler, Law Clerk; Tyler 
Gellasch (Senator Levin); Ted Schroeder, Nhan Nguyen, and Geoff 
Moulden (Senator Kaufman); Mark LeDuc, Neil Cutter, and Ivy 
Johnson (Senator Collins); Michael McBride and John Lawrence 
(Senator Ensign).

               OPENING STATEMENT OF SENATOR LEVIN

    Senator Levin. Good morning, everybody. Our Permanent 
Subcommittee on Investigations will come to order.
    In the fall of 2008, America suffered a devastating 
economic assault. It left deep wounds. Millions lost their 
jobs; millions lost their homes. Good businesses shut down; 
financial markets froze. The stock market plummeted, and once 
valuable securities turned worthless. Storied financial firms 
teetered on the edge or went under. The contagion spread 
worldwide. And in October 2008, American taxpayers were hit 
with a $700 billion bailout of Wall Street. That bailout was a 
bitter pill to swallow, but it stanched the bleeding. The 
economy stabilized, and the Nation and the world began to 
recover.
    Nearly 2 years later, we are still recovering. As part of 
that recovery effort, we as a Nation need to understand what 
went wrong, try to hold perpetrators accountable, and fortify 
our defenses to ward off another such assault in the future.
    To rebuild our defenses, it is critical to understand that 
the recent financial crisis was not a natural disaster. It was 
a man-made economic assault. People did it. Extreme greed was 
the driving force, and it will happen again unless we change 
the rules.
    The Senate has a Subcommittee that is designed to do in-
depth, bipartisan investigations into complex issues. It is the 
Permanent Subcommittee on Investigations, and in November 2008, 
we decided to devote our resources to an examination of some of 
the causes and consequences of the financial crisis which 
continues to this day.
    In the last year and a half, the Subcommittee has dug into 
the facts. To date, we have conducted over 100 interviews and 
depositions. We have consulted with dozens of government, 
academic, and private sector experts on a raft of banking, 
securities, financial, and legal issues. We have collected and 
initiated review of millions of pages of documents. Given the 
extent of the economic damage and the complexity of its root 
causes, the Subcommittee's approach has been to develop 
detailed case studies to examine each stage of the assault and 
lay bare key issues at the heart of the financial crisis.
    Today's hearing is the first in a series designed to 
examine the financial firms, the financial instruments, and the 
regulatory and market safeguards that failed us. We will hold 
four hearings over the next 2 weeks. Throughout, the hearings 
will examine the role of Wall Street and its use of complex 
financial instruments to transact business, from mortgage-
backed securities to collateralized debt obligations (CDOs), 
structured investment vehicles, credit default swaps, and more. 
We will examine how high-risk investments displaced low-risk 
investments, even at taxpayer-insured banks; how 
securitizations and financial engineering ran wild; how 
synthetic investments trumped investments in the real economy; 
and how credit default swaps turned investing in America into 
gambling on the demise of one American company or another. We 
will explore why the regulators, the credit rating agencies, 
and the market itself failed to rein in the abuses.
    The goals of the Subcommittee hearings are threefold: to 
construct a public record of the facts in order to deepen 
public understanding of what happened and try to hold some of 
the perpetrators accountable; to inform the ongoing legislative 
debate about the need for strong financial reforms; and to 
provide a foundation for building better defenses to protect 
Main Street from the excesses of Wall Street.
    So let us start at the beginning with an overview, before 
we plunge into the specifics of today's hearing.
    Prior to the early 1970s, when someone wanted to buy a 
home, typically they went to their local bank or mortgage 
company, applied for a loan, and after providing detailed 
financial information and a downpayment, qualified for a 30-
year fixed-rate mortgage. The local bank or mortgage company 
then commonly kept that mortgage until the homeowner paid it 
off 15 or 30 years later. Bank regulations required lenders to 
keep a certain amount of capital for the loans they issued, so 
there was a limit to how many home loans one bank could have on 
its books.
    Banks got the idea of selling the loans on their books to 
someone else. They made profit on the sales while getting fresh 
capital to make new loans to prospective borrowers. Better yet 
would be if they could sell the loans on their books in bulk in 
quick, efficient, and predictable ways.
    Wall Street came up with the mechanism of securitization. 
Lenders bundle up large numbers of home loans into a loan pool 
and calculate the amount of mortgage payments going into that 
pool from the borrowers. A shell corporation or trust is formed 
to hold the loan pool, and the revenue stream is used to create 
bonds called mortgage-backed securities that could be sold to 
investors. Wall Street firms helped design the loan pools and 
securities, worked with the credit rating agencies to obtain 
favorable ratings for the securities, and sold the securities 
to investors like pension funds, insurance companies, 
municipalities, university endowments, and hedge funds.
    For a while, securitization worked well, but at some point 
things got turned on their head. The fees that banks and Wall 
Street firms made from their securitization activities were so 
large that securitization ceased to be a means to keep capital 
flowing to housing markets and became an end in itself. 
Mortgages began to be produced for Wall Street instead of Main 
Street, and Wall Street bond traders sought more and more 
mortgages in order to generate fees for their companies and 
large bonuses for themselves.
    To satisfy Wall Street's growing appetite for mortgage-
backed securities and to generate additional income for 
themselves, banks began to issue mortgages to not only well-
qualified borrowers, but also high-risk borrowers. High-risk 
loans provided a new fuel for the securitization engines on 
Wall Street. Banks liked high-risk loans because they tended to 
generate higher fees and interest rates and produced more 
profits than low-risk loans. They could also be sold quickly, 
keeping the risk off the bank's books. Wall Street treated high 
interest rate loans like gold ore and were willing to pay more 
for them.
    Lenders began steering borrowers looking for a 30-year 
fixed mortgage to higher-risk loans instead, often using 
gimmicks like low initial teaser rates. Some lenders began 
qualifying borrowers if they could afford to pay a low initial 
rate rather than if they could pay the higher later rate, 
expanding the number of borrowers who could qualify for the 
loan. These practices also allowed borrowers to qualify for 
larger loans.
    When a borrower sought a bigger house, the loan officer or 
mortgage broker profited from higher fees and commissions, the 
bank profited from higher fees and a better price on the 
secondary market, and Wall Street profited from a larger yield 
to be sliced up and sold to investors for big fees. Volume and 
speed, as opposed to loan quality, became the keys to a 
profitable securitization business. Lenders that sold the loans 
they originated passed on the risk and so lost interest in 
whether the sold loans would be repaid. Even some purchasers 
lost interest in the creditworthiness of the securities they 
bought so long as they could purchase insurance in the form of 
credit default swaps that paid off if a mortgage-backed 
security defaulted.
    As long as home prices kept rising, the high-risk loans 
that became fuel for the securitization market posed few 
problems. Those who could not pay off their loans refinanced or 
sold their homes, and as Exhibit 1j \1\ shows--a chart which we 
will put up here--over the 10 years before the crisis hit, 
housing prices shot up faster than they had in decades. Those 
higher home prices were made possible in part by the high-risk 
loans that allowed borrowers to buy more house than they could 
really afford.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 1j, which appears in the Appendix on page 224.
---------------------------------------------------------------------------
    Some who saw the housing bubble was going to burst made 
bets against existing mortgage-backed securities. They sold 
those securities short, even in some cases while selling the 
same securities to their customers. Some even made bets against 
mortgage-backed securities they did not own, using what are 
called naked credit default swaps. Wall Street made money hand 
over fist.
    But the party could not last, and we all know what 
happened. The housing bubble burst, and prices stopped 
climbing. Investors started having second thoughts about the 
mortgage-backed securities being churned out by Wall Street. In 
July 2007, two Bear Stearns offshore hedge funds specializing 
in mortgage-related securities suddenly collapsed. That same 
month, the credit rating agencies downgraded hundreds of 
subprime mortgage-backed securities, and the subprime market 
went cold. Banks, security firms, hedge funds, and other 
investors were left holding suddenly unmarketable mortgage-
backed securities whose value was plummeting. The economic 
assault had begun.
    Banks and mortgage brokers began closing their doors. In 
January 2008, Countrywide Financial Corporation, a $100 billion 
thrift specializing in home loans, was seized by the Federal 
Deposit Insurance Corporation, the FDIC, and sold to the Bank 
of America. That same month, one credit rating agency 
downgraded nearly 7,000 mortgage-backed securities and CDOs, an 
unprecedented mass downgrade.
    In March 2008, as the financial crisis worsened, the 
Federal Reserve engineered the sale of Bear Stearns to JP 
Morgan Chase. In September 2008, in rapid succession, Lehman 
Brothers declared bankruptcy, AIG required an $85 billion 
taxpayer bailout, Fannie Mae and Freddie Mac were taken over by 
the government, and Goldman Sachs and Morgan Stanley converted 
to bank holding companies to gain access to Federal Reserve 
lending programs. A week later, on September 25, 2008, 
Washington Mutual Bank, a $300 billion thrift, then the sixth 
largest depository institution in America, was seized and sold 
to JP Morgan Chase. It was the largest bank failure in U.S. 
history.
    By then, hundreds of billions of dollars in toxic mortgages 
had been dumped into the financial system like polluters 
dumping poison into a river. The toxic mortgages polluted the 
river of commerce not upstream, but downstream, Wall Street 
bottled the polluted water, and rating agencies slapped an 
attractive label on each bottle, promising safe drinking water. 
Wall Street sold the bottles to investors. Regulators observed 
the whole sordid process but did little to stop it while 
profits poured into the participating banks and security firms. 
Investors the world over--pension funds, universities, 
municipalities, and more, not to mention millions of 
homeowners, small businesses, and U.S. taxpayers--are still 
paying the price and footing the cleanup bill. That is the big 
picture.
    Today we start to look at the individual pieces of that 
picture in order to deepen our understanding of what happened. 
We begin by shining a spotlight on the high-risk home loans and 
mortgage-backed securities that those loans produced, using as 
a case history the policies and practices of Washington Mutual 
Bank. This Friday, we will examine the banking regulators 
charged with ensuring the safety and soundness of the U.S. 
banking system, again using Washington Mutual as a case 
history. In the following two hearings, we will turn to the 
role of credit rating agencies, investment banks, and others.
    Washington Mutual Bank (WaMu), rose out of the ashes of the 
great Seattle fire to make its first home loan in 1890. For 
many years, it was a mid-sized thrift specializing in home 
mortgages. In the 1980s and 1990s, WaMu entered a period of 
rapid growth and acquisition, expanding until it became the 
Nation's largest thrift, with $188 billion in deposits and 
43,000 employees. In 2003, its long-term CEO, Kerry Killinger, 
said he wanted WaMu to become the Walmart of banking, catering 
to middle- and lower-income Americans and helping the less well 
off buy homes.
    WaMu held itself out as a well-run, prudent bank that was a 
pillar of its community. But in 2005, WaMu formalized a 
strategy that it had already begun to implement--a movement 
from low-risk to high-risk home loans. That move to high-risk 
lending was motivated by three little words: ``gain on sale.''
    Gain on sale is a measure of the profit made when a loan is 
sold on the secondary market. This chart, which we will put up 
over there, is taken from Exhibit 3 in the books.\1\ It shows a 
slide from an April 18, 2006, PowerPoint presentation entitled 
``Shift to Higher Margin Products,'' which was given to the 
WaMu board of directors by the president of WaMu's Home Loans 
Division.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 3, which appears in the Appendix on page 278.
---------------------------------------------------------------------------
    In the upper left, there is a box in that Exhibit 3 that 
lists the gain on sale for each type of loan that WaMu offers, 
and as you can see from this chart, the least profitable loans 
are government-backed and fixed loans. The most profitable are 
Option ARM, home equity, and subprime loans. Subprime at 150 
basis points is eight times more profitable than a fixed loan 
at 19 basis points.
    Now, those numbers are not estimates or projections, by the 
way. They are the product of actual loan data collected by 
WaMu.
    WaMu traditionally had sold mortgages to well-qualified or 
prime borrowers. But in 1999, WaMu bought Long Beach Mortgage 
Company, LBMC, which was exclusively a subprime lender, lending 
to people whose credit histories did not support their getting 
a traditional mortgage. Long Beach operated by having third-
party mortgage brokers bring proposed subprime loans to its 
doors, issuing financing to the borrower, and paying the 
brokers a fee. Even then, Long Beach made loans for the express 
purpose of packaging them, selling them to Wall Street and 
profiting from the gain on sale.
    In 2003, Long Beach made and securitized about $4.5 billion 
in home loans. By 2006, its loan operations had increased six-
fold, and Long Beach's conveyor belt sent almost $30 billion in 
subprime home loans into the financial system.
    Subprime lending can be a responsible business. Most 
subprime borrowers pay their loans on time and in full. Long 
Beach, however, was not a responsible lender. Its loans and 
mortgage-backed securities were among the worst performing in 
the subprime industry. An internal email at WaMu's primary 
Federal regulator, the Office of Thrift Supervision (OTS), 
stated that Long Beach mortgage-backed securities ``prior to 
2003 have horrible performance.''\1\ LBMC finished in the top 
12 worst annualized net credit losses in 1997 and 1999 through 
2003, and this email said LBMC, or Long Beach, ``nailed down 
the number 1 spot as top loser . . . in 2000 and placed third 
in 2001.''
---------------------------------------------------------------------------
    \1\ See Exhibit No. 8a, which appears in the Appendix on page 388.
---------------------------------------------------------------------------
    In 2003, things got so bad that WaMu's Legal Department put 
a stop to all Long Beach securitizations until the company 
cleaned up its act. An FDIC report noted at the time that of 
4,000 Long Beach loans reviewed, less than one-quarter, about 
950, could be sold to investors.\2\ Another 800 were unsalable, 
and the rest, over half of the loans, had deficiencies that had 
to be fixed before a sale could take place. Several months 
later, WaMu allowed Long Beach to start securitizing its loans 
again as well as selling them in bulk through what were called 
whole loan sales.
---------------------------------------------------------------------------
    \2\ See Exhibit No. 8b, which appears in the Appendix on page 389.
---------------------------------------------------------------------------
    In 2004, trouble erupted again. An internal WaMu audit of 
Long Beach found that ``relaxed credit guidelines, breakdowns 
in manual underwriting processes, and inexperienced subprime 
personnel. . . . coupled with a push to increase loan volume 
and the lack of an automatic fraud monitoring tool'' led to 
deteriorating in loan quality.\3\ Many of the loans defaulted 
within 3 months of being sold to investors. Investors demanded 
that Long Beach repurchase them. Long Beach had to repurchase 
over $875 million in loans in 2005 and 2006, lost over $107 
million from the defaults, and had to cover a $75 million 
shortfall in its repurchase reserves.
---------------------------------------------------------------------------
    \3\ See Exhibit No. 10, which appears in the Appendix on page 408.
---------------------------------------------------------------------------
    In response, WaMu fired Long Beach's senior management and 
moved the company under the direct supervision of the president 
of its Home Loans Division, David Schneider. Washington Mutual 
promised its regulator that Long Beach would improve. But it 
did not.
    In 2008, WaMu's president, Steve Rotella, emailed the CEO, 
Kerry Killinger, that Long Beach's ``delinquencies are up 140% 
and foreclosures close to 70%. . . . It is ugly,'' he wrote.\4\ 
Five months later, in September, he emailed that Long Beach has 
``[r]epurchases, [early payment defaults], manual underwriting, 
very weak servicing/collections practices and a weak 
staff.''\5\ Two months after that, in November 2006, the head 
of WaMu Capital Markets in New York, David Beck, wrote to Mr. 
Schneider that, ``[Long Beach] paper is among the worst 
performing in the market. . . .''\6\
---------------------------------------------------------------------------
    \4\ See Exhibit No. 11, which appears in the Appendix on page 414.
    \5\ See Exhibit No. 12, which appears in the Appendix on page 415.
    \6\ See Exhibit No. 50, which appears in the Appendix on page 670.
---------------------------------------------------------------------------
    At the end of 2006, Long Beach saw another surge in early 
payment defaults. Mr. Schneider sent an email to his 
subordinates that, ``We are all rapidly losing credibility as a 
management team.''\1\ 2008 was no better. Audit after audit 
detailed problems. WaMu's chief risk officer, Ron Cathcart, 
forwarded an email from a colleague about Long Beach, noting 
``Appraisal deficiencies . . . Material misrepresentations . . 
. Legal documents were missing or contained errors or 
discrepancies . . . loan decision errors . . . deterioration 
was accelerating in recent vintages with each vintage since 
2002 having performed worse than the prior vintage.''\2\
---------------------------------------------------------------------------
    \1\ See Exhibit No. 13a, which appears in the Appendix on page 418.
    \2\ See Exhibit No. 16, which appears in the Appendix on page 448.
---------------------------------------------------------------------------
    In June 2007, WaMu shut down Long Beach as a separate 
entity and took over its subprime lending operations. It issued 
several subprime securitizations. The subprime market then 
froze in the fall of 2007, and WaMu ended all of its subprime 
lending. By then, as shown in this chart,\3\ from 2000 to 2007, 
Long Beach and WaMu together had securitized at least $77 
billion in subprime loans.
---------------------------------------------------------------------------
    \3\ See Exhibit No. 1c, which appears in the Appendix on page 214.
---------------------------------------------------------------------------
    Today, although AAA-rated securities are supposed to be 
very safe with low default rates of 1 to 2 percent, Long 
Beach's mortgage-backed securities have loan delinquency rates 
of 20, 30, 40, and even 50 percent, meaning as much as half of 
their underlying loans have gone bad. Those are AAA-rated 
securities.
    Washington Mutual's problems were not confined to its 
subprime operations, and the chart that I referred to is going 
up now showing this huge, steep increase in securitizations of 
Washington Mutual and Long Beach subprime home loans through 
2006. Then, of course, the bottom fell out in 2007.
    Washington Mutual's problems, as I indicated, were not 
confined to its subprime operations. 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 business ``was the worst managed 
business I had seen in my career.''\4\
---------------------------------------------------------------------------
    \4\ See Exhibit No. 79, which appears in the Appendix on page 793.
---------------------------------------------------------------------------
    When Washington Mutual talked about its prime mortgage 
business, it used the term loosely. While the borrowers who 
received loans from WaMu's loan officers tended to have better 
credit scores than Long Beach's subprime borrowers, that was 
not always the case. WaMu loan officers routinely made very 
risky loans to people with below average credit scores. And 
just like at Long Beach, in WaMu's loan business volume was 
king. Loan officers got paid per loan and got paid more per 
loan if certain volume targets were met. Loan processors were 
given volume incentives as well as were entire loan processing 
centers. Even risk managers were evaluated in part on the 
extent to which they supported revenue growth targets. Loan 
officers also got paid more for closing high-risk loans than 
low-risk loans.
    Not surprisingly, people cut corners to keep the conveyor 
belt moving and increase their pay. For example, a April 2008 
placement from a WaMu internal corporate fraud investigator 
states, ``One Sales Associate admitted that during the crunch 
time some of the Associates would `manufacture' asset 
statements from previous loan documents'' because the pressure 
was tremendous and they had been told to get the loans funded, 
``whatever it took.'' \1\ Her words, ``whatever it took.''
---------------------------------------------------------------------------
    \1\ See Exhibit No. 30, which appears in the Appendix on page 544.
---------------------------------------------------------------------------
    In fact, WaMu personnel regularly identified fraud problems 
with its so-called prime loans, but the problems received 
little attention from management. Perhaps the most compelling 
evidence involves two top loan producers at two different WaMu 
offices called Montebello and Downey in Southern California. 
Each of those loan offices made hundreds of millions of dollars 
in home loans each year and consistently won recognition for 
their efforts. In 2005, an internal WaMu review found that 
loans from those two offices had ``an extremely high incidence 
of confirmed fraud.'' These are quotes: ``58 percent for 
Downey, 83 percent for Montebello.''\2\
---------------------------------------------------------------------------
    \2\ See Exhibit No. 23b, which appear in the Appendix on page 511.
---------------------------------------------------------------------------
    The review found that, ``virtually all of it''--and they 
are referring here now to confirmed fraud--``virtually all of 
it stemming from employees in these areas circumventing bank 
policy surrounding loan verification and review.'' \3\ The 
review went on: ``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.''
---------------------------------------------------------------------------
    \3\ See Exhibit No. 22a, which appear in the Appendix on page 496.
---------------------------------------------------------------------------
    That review had taken over a year to complete and was 
discussed with senior management at the bank, including Home 
Loans president, David Schneider, but virtually none of the 
proposed recommendations were implemented. The fraud problem 
was left to fester until 2 years later when, in June 2007, one 
of the bank's mortgage insurance companies refused to insure 
any more loans issued by the loan producer from the Montebello 
office and complained to WaMu's State and Federal regulators 
about fraudulent borrower information.
    WaMu then conducted another internal investigation, this 
one lasting 10 months. In April 2008, a WaMu audit and legal 
team produced an internal memorandum which at first WaMu tried 
to keep from its regulator, OTS. But the OTS examiner in charge 
demanded to see the memorandum, and it was eventually turned 
over. He told our staff that once he read it, he considered it 
``the last straw'' that changed his view of how the bank dealt 
with fraud.
    The April 2008 memorandum, which is Exhibit 24,\4\ stated 
that employees at the Montebello Loan Center ``consistently 
described an environment where production volume rather than 
quality and corporate stewardship were the incented focus.'' At 
that loan center, 62 percent of the sampled loans from 2 months 
in 2007 contained misrepresentations and suspected loan fraud. 
The memorandum noted that similar levels of fraud had been 
uncovered at the same loan center in 2005, and that no action 
had been taken in response. The memorandum raised the question 
of whether the billions of dollars in loans from that center 
should be reviewed given the longstanding fraud problem and the 
fact that the loans may have been sold to investors. Those 
fraudulent loans, shocking in themselves, were symptomatic of a 
larger problem.
---------------------------------------------------------------------------
    \4\ See Exhibit No. 24, which appears in the Appendix on page 515.
---------------------------------------------------------------------------
    WaMu failed to ensure that its employees issued loans that 
met the bank's credit requirements. Report after report 
indicated that WaMu loan personnel often ignored the bank's 
credit standards. December 12, 2006, minutes from a WaMu Market 
Risk Committee stated, for example, ``[d]elinquency behavior 
was flagged in October [2006] for further review and analysis. 
. . . The primary factors contributing to increased delinquency 
appear to be caused by process issues including the sale and 
securitization''--sale and securitization--``of delinquent 
loans, loans not underwritten to standards, lower credit 
quality loans and seller services reporting false delinquent 
payment status.''\1\
---------------------------------------------------------------------------
    \1\ See Exhibit No. 28, which appears in the Appendix on page 537.
---------------------------------------------------------------------------
    A September 2008 review found that controls intended to 
prevent the sale of fraudulent loans to investors were ``not 
currently effective,'' and there was no ``systematic process to 
prevent a loan . . . confirmed to contain suspicious activity 
from being sold to an investor.''\2\ In other words, even where 
a loan was marked with a red flag indicating fraud, that did 
not stop the loan from being sold to investors. The 2008 review 
found that of 25 loans tested, ``11 reflected a sale date after 
the completion of the investigation which confirmed fraud'' and 
said ``there is evidence that this control weakness has existed 
for some time.''
---------------------------------------------------------------------------
    \2\ See Exhibit No. 34, which appears in the Appendix on page 564.
---------------------------------------------------------------------------
    Sales associates manufacturing documents, large numbers of 
loans that don't meet credit standards, offices issuing loans 
in which 58, 62, or 83 percent contained evidence of fraudulent 
borrower information, loans marked as containing fraud but then 
sold to investors anyway--those are massive, deep-seated 
problems, and they are problems that inside the bank were 
communicated to senior management but were not fixed.
    Now, WaMu's flagship mortgage product, the Option ARM, was 
also marked by shoddy lending practices. The Option ARM is an 
adjustable rate mortgage which typically allowed borrowers to 
pay an initial ``teaser rate,'' sometimes as low as 1 percent 
for the first month, and then imposed a much larger floating 
interest rate linked to an index. The option in the loan name 
refers to an arrangement which allowed borrowers to choose each 
month among four types of payments: payments that would pay off 
the loan in 15 or 30 years, an interest-only payment, or a 
minimum payment that did not cover even the interest owed, much 
less the principal.
    If the minimum payment options were chosen, the unpaid 
interest would be added to the loan's principal, causing the 
loan amount to increase rather than decrease over time. In 
other words, the borrower could make payments as required but 
still owe the bank more money on the principal each month. It 
was a negative amortizing loan.
    Option ARMs allowed borrowers to make very low minimum 
payments for a specified period of time, before being switched 
to higher payment amounts. Most borrowers chose the minimum 
payment option. After 5 years, or when the loan principal 
reached a specific amount of negative amortization, such as 110 
or 115 or 125 percent of the original loan amount, whichever 
came first, the Option ARM would recast. The borrower would 
then be required to make the fully amortizing payment needed to 
pay off the loan within the remaining loan period. The required 
payment was typically much greater, often double the prior 
payment, causing payment shock and increasing loan defaults.
    WaMu was eager to steer borrowers to Option ARMs. Because 
of the gain from their sale, the loans were profitable for the 
bank, and because of the compensation incentives, they were 
profitable for mortgage brokers and loan officers. In 2003, 
WaMu held focus groups with borrowers, loan officers, and 
mortgage brokers to determine how to push that product. A 2003 
report summarizing the focus group research stated, ``Few 
participants fully understood the Option ARM. . . . 
Participants generally chose an Option ARM because it was 
recommended to them by their loan consultant. . . . Only a 
couple of people had any idea how the interest rate on their 
loan was determined.''\1\
---------------------------------------------------------------------------
    \1\ See Exhibit No. 35, which appears in the Appendix on page 569.
---------------------------------------------------------------------------
    It said that while borrowers ``generally thought that 
negative amortization was a moderately or very bad concept,'' 
that perception could be turned around by mentioning ``that 
price appreciation would likely overcome any negative 
amortization.'' And the report stated, ``The best selling point 
for the Option ARM loan was [borrowers] being shown how much 
lower their monthly payment would be . . . versus a fixed-rate 
loan.''
    That year, 2003, WaMu originated $30 billion in Option 
ARMs. To increase Option ARM sales, WaMu increased the 
compensation paid to employees and outside mortgage brokers for 
the loans and allowed borrowers to qualify for the loan by 
evaluating whether those borrowers could pay a low or even the 
minimum amount available under the loan rather than the higher 
payments that would follow recast. In 2004, WaMu doubled its 
production of Option ARMs to more than $67 billion.
    WaMu loan officers told the Subcommittee that they expected 
the vast majority of Option ARM borrowers to sell or refinance 
their homes before their payments increased. As long as home 
prices were appreciating, most borrowers were able to 
refinance. Once housing prices stopped rising, however, 
refinancing became difficult. At recast, many people became 
stuck in homes they could not afford and began defaulting in 
record numbers.
    WaMu became one of the largest originators of those types 
of loans in the country. From 2006 until 2008, WaMu securitized 
or sold a majority of the Option ARMs it originated, infecting 
the financial system with these high-risk mortgages. Like Long 
Beach securitizations, WaMu Option ARM securitizations 
performed badly starting in 2006, with loan delinquency rates 
between 30 and 50 percent and rising.
    Destructive compensation schemes played a role in the 
problems just described. Hearing exhibits will show how 
Washington Mutual and Long Beach compensated their loan 
officers and processors for loan volume and speed over loan 
quality. Loan officers were also paid more for overcharging 
borrowers, obtaining higher interest rates or more points than 
called for in the loan pricing set out in the bank's rate 
sheets, and were paid more for including stiff prepayment 
penalties. Loan officers and third-party mortgage brokers were 
also paid more for originating high-risk loans than low-risk 
loans. These incentives contributed to shoddy lending practices 
in which credit evaluations took a back seat to approving as 
many loans as possible.
    The compensation problems didn't stop in the loan offices. 
They went all the way to the top. WaMu's CEO received millions 
of dollars in pay, even when his high-risk loan strategy began 
losing money, 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. That is on top of four 
retirement plans, a deferred bonus plan, and a separate 
deferred compensation plan. In 2008, when he was asked to leave 
the bank, Mr. Killinger was paid $25 million, including $15 
million in severance pay. That is $25 million for overseeing 
shoddy lending practices that pumped billions of dollars of bad 
mortgages into the financial system, another painful example of 
how executive pay at some U.S. financial firms rewards failure.
    The information uncovered by this Subcommittee is laid out 
in over 500 pages of exhibits. These documents detail not only 
the shoddy lending practices at Washington Mutual and Long 
Beach, they show what senior management knew and what they said 
to each other about what they found. Senior executives 
described Long Beach as, ``terrible'' and ``a mess,'' with 
default rates that were, ``ugly.'' With respect to WaMu retail 
home loans, internal reviews described, ``extensive fraud'' 
from employees willfully, ``circumventing bank policy.'' 
Controls to stop fraudulent loans from being sold to investors 
were described as, ``ineffective.'' WaMu's president described 
it as, ``the worst managed business he had seen in his 
career.'' That was the reality inside Washington Mutual.
    To keep that conveyor belt running and feed the 
securitization machine on Wall Street, Washington Mutual 
engaged in lending practices that created a mortgage time bomb. 
We have an exhibit, Exhibit 1b,\1\ which summarizes the lending 
practices that produced high-risk mortgages and junk 
securities, including targeting high-risk borrowers, steering 
borrowers to higher-risk loans, increasing sales of high-risk 
loans to Wall Street, not verifying income and using stated 
income or liar loans, accepting inadequate documentation loans, 
promoting teaser rates, interest-only and pick-a-payment loans 
which were often negatively amortizing, ignoring signs of 
fraudulent borrower information, and more.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 1b, which appears in the Appendix on page 213.
---------------------------------------------------------------------------
    The last two bullet points on the chart deserve particular 
scrutiny. We are going to hear today how, at a critical time, 
Washington Mutual securitized loans that had been selected 
specifically for sale because they were likely to go delinquent 
without informing investors of that fact. Getting them sold 
became an urgent goal. We will also hear that, at times, 
Washington Mutual securitized loans that had already been 
identified as being fraudulent, also without informing 
investors.
    WaMu built its conveyor belt of toxic mortgages to feed 
Wall Street's appetite for mortgage-backed securities. Because 
volume and speed were king, loan quality fell by the wayside 
and WaMu churned out more and more loans that were high-risk 
and poor quality. Once a Main Street bank focused on financing 
mortgages for its customers, Washington Mutual was taken in by 
the short-term profits that even poor-quality mortgages 
generated on Wall Street.
    Washington Mutual was not, of course, the only one running 
a conveyor belt, dumping high-risk, poor-quality mortgages into 
the financial system. Far from it. Some of the perpetrators 
like Countrywide and New Century have already been hit with 
Federal enforcement actions and shareholder lawsuits. Others 
may never be held accountable. But all of us are still paying 
the price.
    This Subcommittee investigation and the Wall Street 
excesses that we have uncovered provide an eerie replay of a 
1934 Senate Committee investigation into the causes and 
consequences of the 1929 Stock Market Crash. That 1934 
investigation found, among other things, the following.
    ``One, many instances where investment bankers were 
derelict in the performance of their fundamental duty to the 
investing public to safeguard, to the best of his ability, the 
intrinsic soundness of the securities that he issues.
    ``Two, an utter disregard by officers and directors of 
banks of the basic obligations and standards arising out of the 
fiduciary relationship extending not only to stockholders and 
depositors but to persons seeking financial accommodation or 
advice.
    ``Three, compensation arrangements that were an incentive 
to bank and securities officers to have the institutions engage 
in speculative transactions and float securities issues which 
were hostile to the interests of these institutions and the 
investing public.
    ``Four, in retrospect, the fact will emerge with increasing 
clarity, this investigation found, that the excessive and 
unrestrained speculation which dominated the securities markets 
in recent years has disrupted the flow of credit, dislocated 
industry and trade, impeded the flow of interstate commerce, 
and brought in its train social consequences inimical to the 
public welfare.''
    That is what the Senate Committee found in 1934. 
Ironically, several of the banks investigated in 1934 were also 
participants in the 2008 financial crisis, another crisis 
fueled by Wall Street excesses.
    The question facing Congress is whether we have the 
political will to try to curb those excesses. Hopefully, this 
investigation and our findings and recommendations will help 
strengthen the political will to put an end to the excesses of 
Wall Street.
    Finally, I want to commend my Ranking Member, Senator 
Coburn, and his staff for their great support and involvement 
in this investigation. They have walked with us. They have 
worked with us each step of the way. I now turn to Senator 
Coburn for his opening remarks.

              OPENING STATEMENT OF SENATOR COBURN

    Senator Coburn. Thank you, Mr. Chairman. Thank you for 
having this hearing. I think it is going to be beneficial as we 
go through the process of all of these hearings in looking at 
what happened, and why it happened.
    We know that risky home loans played a particularly 
important part in the financial crisis that befell us. While we 
are focusing today on the case study of Washington Mutual, this 
is merely a starting chapter in a much longer and very complex 
story.
    The tale of WaMu is emblematic of what happened to many 
home lenders in the never-ending effort to grow and get a 
larger share of the booming housing market. Traditional risk 
management gave way to the chase for volume and profit. When 
the housing market finally tanked, WaMu and other lenders 
imploded.
    WaMu was no fly-by-night operation. As the sixth-largest 
bank in the country with over $330 billion in assets, it had 
more than a century of experience in the mortgage business. It 
bragged often that it survived both the Great Depression and 
the savings and loan crisis. Make no mistake, the collapse of 
this institution is a very big deal. Following by just 10 days 
the collapse of Lehman Brothers, WaMu's collapse helped send 
the financial markets into a tailspin. Confidence was king in 
those few days, and seeing a giant mortgage lender fail and 
fall so fast sent a chill through Wall Street.
    Our investigation has focused on the 5-year period between 
2003 and 2008 following WaMu's decision to dive head first into 
high-risk lending. The bank drastically altered its business 
model from long-term fixed-rate mortgages to higher-risk loans 
made to higher-risk borrowers. Easy money from the Federal 
Reserve and soaring home values created in WaMu executives a 
misplaced sense of confidence. Whereas before, taking on risk 
was something that was approached with caution, the fact would 
now seem that it was a fast and easy way to make money.
    WaMu's corporate culture had no place for individuals 
concerned about high-risk lending, but instead brushed them 
aside and ignored them, according to the testimony that we have 
received. Sales associates have admitted that they were under 
immense pressures to sell and just get the loans done. Add to 
that the environment of a voracious appetite for mortgage-
backed securities from Wall Street and Fannie Mae and Freddie 
Mac, and all the pieces were in place for an epic fall of this 
once venerable financial institution.
    As competition for borrowers grew and granting loans to 
those with questionable credit histories and less-than-complete 
documentation became all the rage, underwriting standards 
started to verge on the absurd. WaMu emphasized the power of 
and made sure anyone and everyone got a loan. Something is 
definitely wrong when you need more documentation to rent a 
movie than to get a $1 million home loan.
    We here in Congress are certainly not without blame. Like 
so many Americans, for years, we insisted on seeing the housing 
market through rose-colored glasses. Congress failed to do its 
oversight on Fannie Mae and Freddie Mac, failed to do its 
oversight on the Federal Reserve, failed to do its oversight on 
the FDIC, and failed to do its oversight in any other number of 
areas, including the SEC. We failed to do the correct oversight 
that would have brought these things to light earlier, before 
we had such a catastrophe.
    Because of reckless Federal policies, too many families 
found themselves locked into mortgages they did not understand 
and absolutely could not afford. In my home State of Oklahoma, 
we have suffered 22,000 foreclosures in the past 18 months and 
50,000 foreclosures are projected by 2012.
    As we move forward, understanding events like the collapse 
of WaMu are essential to ensuring that we do not make the same 
mistakes again. But I will emphasize again, the mistakes didn't 
have to be made had Congress done its job, and we failed 
miserably.
    I look forward to hearing from our witnesses today and I 
look forward to being the pinprick to make sure that we 
continue to do the oversight in the future, and I thank you, 
Mr. Chairman.
    Senator Levin. Thank you very much, Senator Coburn.
    Let me now call our first panel of witnesses for this 
morning's hearing: James Vanasek, the former Chief Credit 
Officer from 1999 to 2004 and Chief Risk Officer from 2004 to 
2005 of Washington Mutual Bank; Ronald Cathcart, the Chief Risk 
Officer of Washington Mutual Bank from 2006 to 2008; and Randy 
Melby, the former General Auditor of Washington Mutual Bank. We 
appreciate each of you being with us this morning.
    Pursuant to Rule 6, all witnesses who testify before the 
Subcommittee are required to be sworn, so I would ask each of 
you to stand. Please raise your right hand.
    Do you swear that the testimony you are about to give to 
this Subcommittee will be the truth, the whole truth, and 
nothing but the truth, so help you, God?
    Mr. Vanasek. I do.
    Mr. Cathcart. I do.
    Mr. Melby. I do.
    Senator Levin. We are going to be using a timing system 
today. About one minute before the red light comes on, you will 
see the light change from green to yellow, which will give you 
an opportunity to conclude your remarks. Your written testimony 
will be printed in its entirety in the record. We would ask 
that you attempt to limit your oral testimony to no more than 5 
minutes.
    Mr. Vanasek, we are going to have you go first, followed by 
Mr. Cathcart, and then finish up with Mr. Melby, and then we 
will turn to questions after that is concluded.
    Mr. Vanasek, please proceed. Make sure your microphone is 
on, too, and that you speak right into it.

 TESTIMONY OF JAMES G. VANASEK,\1\ FORMER CHIEF CREDIT OFFICER 
  (1999-2004) AND CHIEF RISK OFFICER (2004-2005), WASHINGTON 
                          MUTUAL BANK

    Mr. Vanasek. OK. Mr. Chairman, Senator Coburn, and 
distinguished Members of the Committee, thank you for the 
opportunity to discuss the mortgage and financial crisis from 
the perspective of a Chief Credit Officer in the sixth-largest 
bank in this country.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Vanasek appears in the Appendix 
on page 134.
---------------------------------------------------------------------------
    I was the Chief Credit Officer and later the Chief Risk 
Officer of Washington Mutual during the period of September 
1999 to December 2005, when I retired. Prior to serving in this 
capacity, I had worked for several large banking companies in 
senior credit-oriented roles, including PNC, First Interstate 
Bank, Norwest/Wells Fargo. Altogether, I have 38 years of 
experience in credit-oriented positions and have been fortunate 
enough to have well-established histories and constructive 
relationships with all of the major banking regulators.
    The failure of Washington Mutual occurred in September 
2008, nearly 3 years after my retirement, so much of what I 
will tell you today is historical information about the 
company's strengths and weaknesses during the years of my 
direct involvement.
    Washington Mutual was a reflection of the mortgage industry 
characterized by very fast growth, rapidly expanding product 
lines, and deteriorating credit underwriting. This was a hyper-
competitive environment in which mistakes were made by loan 
originators, lending institutions, regulatory agencies, rating 
agencies, investment banks that packaged and sold mortgage-
backed securities, and the institutions that purchased these 
excessively complex instruments.
    It was both the result of individual failures and systemic 
failures fueled by self interest, failure to adhere to lending 
policies, very low interest rates, untested product 
innovations, weak regulatory oversight, astonishing rating 
agency lapses, weak oversight by boards of directors, a 
cavalier environment on Wall Street, and very poorly structured 
incentive compensation systems that paid for growth rather than 
quality.
    One must also seriously question the wisdom of the 
elimination of Glass-Steagall and its impact on the 
securitization market.
    Washington Mutual was a company that had grown with 
exceptional speed due to acquisitions primarily in California 
during the industry crisis of the early 1990s. By 2000, it was 
a company in search of identity. At one point, the CEO wanted 
the company to expand the commercial lending area in an effort 
to earn a higher price earnings ratio on the stock, only to 
abandon the strategy 3 years later.
    The focus then shifted to rapidly expanding the branch 
network by opening as many as 250 locations within 12 months in 
cities where the company had no previous retail banking 
experience. Ultimately, this proved to be an unsuccessful 
strategy due in part to the effort to grow too quickly.
    The focus then shifted away from the diversification to 
becoming the so-called low-cost producer in the mortgage 
industry. This effort was likewise unsuccessful, in large 
measure due to an expensive undertaking to write a completely 
new mortgage loan origination and accounting software system 
that ultimately failed and had to be written off.
    By mid-2005, the focus had shifted again to becoming more 
of a higher-risk subprime lender at exactly the wrong time in 
the housing market cycle. This effort was characterized by 
statements advocating that the company become either via 
acquisition or internal growth a dominant subprime lender. In 
addition to subprime, the company was a large lender of 
adjustable-rate mortgages, having had 20 years' experience with 
the product. As in the case of subprime, the product had only 
been available to a narrow segment of customers. Adjustable-
rate mortgages were sold to an ever-wider group of borrowers. 
Product features were also expanded.
    Historically, plain vanilla mortgage lending had been a 
relatively safe business. During the period 1999 to 2003, 
Washington Mutual mortgage losses were substantially less than 
one-tenth of one percent, far less than losses of commercial 
banks. But rapidly increasing housing prices masked the risks 
of a changing product mix and deteriorating underwriting, in 
part because borrowers who found themselves in trouble could 
almost always sell their homes for more than the mortgage 
amount, at least until 2006 or 2007.
    There is no one factor that contributed to the debacle. 
Each change in product features and underwriting was 
incremental and defended as necessary to meet competition. But 
these changes were taking place within the context of a rapidly 
increasing housing price environment and were, therefore, 
untested in a less favorable economic climate.
    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.
    The appetite of Wall Street and investors worldwide created 
huge demand for high-yielding subprime mortgages that resulted 
in a major expansion of what was historically a relatively 
small segment of the business led by Household Finance. The 
Community Reinvestment Act also contributed by demanding 
loans--that banks make loans to low-income families, further 
expanding subprime lending.
    One obvious question is whether or not these risks were 
apparent to anyone in the industry or among the various 
regulatory or rating agencies. There is ample evidence in the 
record to substantiate the fact that it was clear that the 
high-risk profile of the entire industry, to include Washington 
Mutual, was recognized by some but ignored by many. Suffice it 
to say, meeting growth objectives to satisfy the quarterly 
expectations of Wall Street and investors led to mistakes in 
judgment by the banks and the mortgage lending company 
executives. A more difficult question is why boards of 
directors, regulatory agencies, and rating agencies were 
seemingly complacent.
    Another question may be my personal role and whether I made 
significant effort to alter the course of lending at Washington 
Mutual. In many ways and on many occasions, I attempted to 
limit what was happening. Just a few examples may suffice.
    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.
    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.
    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.
    There have been questions about policy and adherence to 
policy. This was a continual problem at Washington Mutual, 
where line managers, particularly in the mortgage area, not 
only authorized but encouraged policy exceptions. There had 
likewise been issues regarding fraud. 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.
    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.
    Another way I attempted to counteract the increasing risk 
was to increase the allowance for loan and lease loss to cover 
the potential losses. Regrettably, there has been a 
longstanding unresolved conflict between the SEC and the 
accounting industry on one side and the banks and the bank 
regulators regarding reserving methodology. The SEC and 
accounting profession believed that more transparency in bank 
earnings is essential to investors and that the way to achieve 
transparency is to keep reserves at levels reflecting only very 
recent loss experience. But banking is a cyclical business, 
which the banks and the bank regulators recognize. It is their 
belief and certainly my personal belief that building reserves 
in good times and using those reserves in bad times is the 
entire purpose of the loan loss reserves. What is more, the 
investors, the FDIC, and the industry are far better protected 
reserves that are intended to be sufficient to sustain the 
institution through the cycle rather than draining reserves at 
the point where losses are at their lowest point.
    At one point, I was forced by external auditors to reduce 
the loan loss reserve of $1.8 billion by $500 million or risk 
losing our audit certification. As the credit cycle unfolded, 
those reserves were sorely needed by the institution. In my 
opinion, the Basel Accord on bank capital requirements repeats 
the same mistake of using short-term history rather than 
through-the-cycle information to establish required capital 
levels, and as such has been a complete and utter failure.
    The conventional wisdom repeated endlessly in the mortgage 
industry and at Washington Mutual was that while there had been 
regional recessions and price declines, there had never been a 
true national housing price decline. I believe that is 
debatable. But it was widely believed, and partially on this 
premise, the industry and Washington Mutual marched forward 
with more and more subprime high loan-to-value and option 
payment products, each one adding incrementally to the risk 
profile.
    Thank you for your time and attention. I will be happy to 
address your questions.
    Senator Levin. Thanks, Mr. Vanasek. Mr. Cathcart.

  TESTIMONY OF RONALD J. CATHCART,\1\ FORMER CHIEF ENTERPRISE 
        RISK OFFICER (2006-2008), WASHINGTON MUTUAL BANK

    Mr. Cathcart. Chairman Levin, Ranking Member Coburn, and 
Members of the Committee, thank you for the opportunity to 
comment on my history with Washington Mutual Bank and to 
provide a risk management perspective on some root causes of 
the U.S. financial services crisis.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Cathcart appears in the Appendix 
on page 138.
---------------------------------------------------------------------------
    Before leading the Enterprise Risk Management Group at 
WaMu, I spent more than 20 years working in risk management 
positions at World Bank of Canada, Bank One, and CIBC. I joined 
WaMu's management team in December 2005 and served as the Chief 
Enterprise Risk Officer through April 2008.
    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. I 
understood that the regulatory agencies and WaMu's Board of 
Directors were interested in expanding risk management 
functions within the company to meet this demand. The general 
function of risk management is to measure, monitor, and 
establish parameters to control risk so that the company is 
prepared for potential loss. In order to meet this objective, 
during my first few months, I reorganized the department in 
order to align risk management with the company's business 
lines and to embed risk managers in each of the four business 
units.
    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 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.
    In hindsight, the shift to both adjustable-rate Option ARM 
loans and subprime products was a significant factor in the 
failure of WaMu and contributed to the financial crisis 
generally. These products depended on house price appreciation 
to be viable. When housing prices decelerated, they became 
problem assets.
    In early 2006, a high volume of Option ARM loans was being 
originated and securitized at WaMu and throughout the West 
Coast mortgage industry. Wall Street had a huge appetite for 
Option ARMs and WaMu could sell these loans as quickly as it 
could originate them. With an incentive to bundle and sell 
large quantities of loans as quickly as possible, banks all 
over the country, including WaMu, became conduits for the 
securitization and sale of loans to Wall Street. The banking 
industry began to move away from the traditional model, where 
banks held the loans they originated, towards a new model where 
banks acted as conduits. The demand for securitized mortgage 
products encouraged poor underwriting, and guidelines which had 
been established to mitigate and control risk were often 
ignored.
    The source of repayment for each mortgage shifted away from 
the individual and their credit profile to the value of the 
home. This approach of focusing on the asset rather than on the 
customer ignores the reality that portfolio performance is 
ultimately determined by customer selection and credit 
evaluation. Even the most rigorous efforts to measure, monitor, 
and control risk cannot overcome poor product design and weak 
underwriting and organizational practices.
    Another key component of WaMu's higher-risk strategy 
involved efforts to increase the company's exposure to the 
subprime market. These efforts focused on lending to customers 
who did not meet the credit qualifications to obtain 
traditional mortgages. In order to be successful, any bank 
offering subprime products must operate with a high degree of 
credit discipline. However, the credit performance of Long 
Beach-originated loans did not meet acceptable risk standards 
and the high level of early payment defaults suggested poor 
customer selection and underwriting practices. Risk management, 
therefore, determined that Long Beach had outsized risk 
parameters and we implemented standards to tighten them.
    In the end, WaMu's subprime exposure never reached the 
levels envisaged in the 2005 strategy. In fact, thanks in part 
to tightening of controls and risk parameters, these were 
reduced.
    Financial conditions in late 2007 and early 2008 
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.
    In conclusion, let me identify some of the factors which 
contributed to the decline of the U.S. financial market. A 
confluence of factors came together to create unprecedented 
financial conditions which the market was not equipped to 
handle. Due to a lack of regulation and lax lending standards, 
mortgage brokers operated without oversight and underwriting 
quality suffered as a result. The banking industry's focus 
shifted from customer selection to asset-based lending as banks 
became conduits for Wall Street, which could and would 
securitize whatever mortgage pool the bank originated. Rating 
agencies and regulators seemed to be lulled into a sense of 
complacency, and the Government-Sponsored Enterprises opened 
their risk envelopes and guaranteed and warehoused increasingly 
risky products.
    Thank you for the opportunity to share my thoughts and 
experiences. I look forward to the Subcommittee's review of 
this matter and I am prepared to answer any questions.
    Senator Levin. Thank you very much, Mr. Cathcart. We thank 
you all for your statements, which we have had an opportunity 
to read.
    Mr. Melby.

TESTIMONY OF RANDY MELBY,\1\ FORMER GENERAL AUDITOR, WASHINGTON 
                          MUTUAL BANK

    Mr. Melby. Mr. Chairman and Members of the Subcommittee, 
good morning. My name is Randy Melby. I joined WaMu in June 
2004 and became general auditor in December 2004. I have close 
to 30 years of bank experience with 27 of those years as a 
professional internal auditor for Norwest, who later acquired 
Wells Fargo, and 2 years leading a large commercial loan 
operations division for Wells Fargo, along with my current 
position as chief risk officer for BankUnited in Miami Lakes, 
Florida. I am also a certified internal auditor.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Melby appears in the Appendix on 
page 146.
---------------------------------------------------------------------------
    As general auditor for WaMu, I reported directly to the 
chairman of the Audit Committee of the corporate board of 
directors and administratively to the chief risk officer who 
reported directly to the CEO. I was not a member of the 
executive committee, which was comprised of the CEO's direct 
reports and select direct reports of the president and COO.
    My primary role as general auditor was to provide an 
independent, objective assessment of WaMu's system of internal 
control and underlying business processes. We conducted our 
work in accordance with the Institute of Internal Auditors' 
Standards for the Professional Practice of Internal Auditing 
and Code of Ethics and employed the Committee of Sponsoring 
Organizations of the Treadway Commission, or more commonly 
referred to as COSO, for defining, evaluating, testing, and 
reporting on WaMu's policies, processes, and information 
systems.
    My primary objectives were twofold: One, to assist the 
board, management, and employees in the effective discharge of 
their responsibilities by providing analysis, testing, 
recommendations, advice, and information concerning the 
adequacy and effectiveness of WaMu's internal control structure 
related to safeguarding of assets, compliance with applicable 
laws and regulations, and achievement of management's 
operational objectives; and, two, to promote effective business 
processes to internal control at a reasonable cost.
    The board, management, and employees of WaMu were 
accountable and responsible for establishing both an adequate 
and effective internal control environment and for balancing 
risk and reward in determining and executing business 
strategies. In other words, internal audit does not set or 
determine business strategies. We audit those processes 
established to execute against business strategies determined 
by both the board and management. As defined by COSO, internal 
control is a process effected by the board, management, and 
employees designed to provide reasonable assurance regarding 
the achievement of objectives related to the effectiveness and 
efficiency of operations, reliability of financial reporting, 
and compliance with applicable laws and regulations.
    I was hired by the Audit Committee to assist the board, 
management, and employees strengthen WaMu's overall system of 
internal control by improving and upgrading its internal audit 
function.
    When I joined WaMu in 2004, the company was at the tail end 
of a string of significant acquisitions that resulted in, among 
other things, multiple and disparate systems and a manually 
intensive business process environment. And the Internal Audit 
Department was very traditional and in need of being elevated 
to the next level of professionalism, credibility, and to be 
positioned as a forerunner in effecting change and delivering 
strategic and value-added internal audit services.
    For example, in 2005, we turned over close to 50 percent of 
the audit staff, or approximately 40 to 45 people. Most of this 
turnover was by design, and we began upgrading the overall 
quality and experience of the audit team. Turnover was cut in 
half to 24 percent in 2006 and improved to below 20 percent in 
2008, which is in line with other large financial services' 
internal audit departments. In addition, 2005 was a year where 
we focused on our Internal Audit Department infrastructure by 
initiating an audit process improvement project, enhanced our 
professional practices group, developed internal metrics and 
MIS, started performing cross-organizational audits, and 
improved overall Audit Committee reporting.
    In 2006, I hired a deputy general auditor, an IT audit 
director, a professional practices audit director, and an audit 
director to oversee and redesign our audit approach for 
assessing credit risk. All came from outside of WaMu and 
reported directly to me and came with over 75 combined years of 
internal audit experience.
    These changes were significant, specifically as it relates 
to credit risk. Corporate Credit Review was positioned within 
WaMu as an independent function that was separate from internal 
audit. This group was responsible for providing an independent 
assessment of WaMu's overall credit risk and credit quality and 
reported up through the enterprise chief risk officer. These 
changes were designed to provide enhanced audit coverage of the 
credit review function. We redesigned our audit processes. The 
company acquired Providian Card Services, and we integrated the 
Providian audit team into our Audit Department, approximately 
30 professional internal auditors, and we continued performing 
more risk-based and strategic audits.
    Last, we received an external review, which is required by 
the Institute of Internal Auditors' Standards for the 
Professional Practice of Internal Auditing, and received the 
highest rating assigned.
    In 2007, we continued hiring external talent to keep pace 
with the rapid changes occurring within WaMu. We achieved our 
full staffing plan for the first time since I joined the 
company, which allowed us to reduce our reliance on external 
co-source resources. We enhanced the overall quality of our 
ongoing risk assessments with the focus on emerging risks, and 
Corporate Fraud Investigations was merged and integrated into 
the Audit Department, and I hired an Investigations Director 
from the outside who reported directly to me.
    In 2008, we continued enhancing the quality of our 
assurance work. We enhanced our continuous risk assessment 
process with a focus on enterprise-wide risk assessments, and 
we continued performing high-risk, cross-organizational audits.
    Last, during my tenure as General Auditor, Internal Audit 
consistently reported to executive management and the Audit 
Committee those areas of the company that required significant 
improvement as well as those areas that were well controlled.
    I look forward to answering any of your questions to the 
best of my ability. Thank you.
    Senator Levin. Thank you very much.
    We are going to have an opening round, which is a 20-minute 
opening round, so that each of us will take up to that. In our 
subsequent rounds, we may have a little shorter period, but we 
will start with that approach.
    First, let me start with questions about Long Beach 
Mortgage. This was WaMu's primary subprime lender. Let me start 
with you, Mr. Vanasek. Did Long Beach have an effective risk 
management regime when you arrived at WaMu?
    Mr. Vanasek. No, sir, they did not.
    Senator Levin. And did they develop an effective risk 
management regime while you were there?
    Mr. Vanasek. No, sir, they did not.
    Senator Levin. Mr. Cathcart, when you were there from 2006 
to 2008 at WaMu, did Long Beach have an effective risk 
management regime?
    Mr. Cathcart. No, sir.
    Senator Levin. Thank you. Now, since Long Beach was 
exclusively a subprime lender, its loans were all high risk in 
a sense. I gather that subprime loans are high risk for a 
number of reasons. Is that correct?
    Mr. Cathcart. Yes, that is correct.
    Senator Levin. Mr. Vanasek, would you agree?
    Mr. Vanasek. Yes, I agree.
    Senator Levin. Now, take a look, if you all would, at 
Exhibit 1c.\1\ This is based on WaMu data, and it shows the 
Long Beach and WaMu securitizations of subprime loans. In 6 
years, starting from 2000 all the way through 2006, the 
securitization of subprime home loans went from $2.5 billion 
all the way up to $29 billion. And then in 2007, the number 
dropped dramatically, not because Long Beach decided to stop 
securitizing loans, but because by September of that year, 
investors had stopped buying subprime mortgage-backed 
securities. The credit rating agencies had started to downgrade 
those securities in July, and the market froze at that point.
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    \1\ See Exhibit No. 1c, which appears in the Appendix on page 214.
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    Mr. Vanasek and Mr. Cathcart, did either of you become 
involved with managing the risks associated with securitization 
at Long Beach?
    Mr. Vanasek. No, sir.
    Mr. Cathcart. No, sir.
    Senator Levin. All right. Is it fair to say that WaMu was 
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.
    Mr. Vanasek. Yes, I would say that was a fair 
characterization. From the beginning, all Long Beach mortgage 
loans were sold to the street.
    Senator Levin. And then the risk, therefore, would be 
passed on to the purchasers. Is that correct?
    Mr. Vanasek. Yes.
    Senator Levin. Mr. Cathcart, do you agree with that?
    Mr. Cathcart. Well, there was a retained interest in the 
securitized assets in the neighborhood of $200 or $300 million 
that did represent risk to the bank.
    Senator Levin. For the part that was retained, which was a 
small percentage.
    Mr. Cathcart. That is correct. And that ended up being 
written off. But to that extent, there was a residual risk. 
Other than that, the loans were securitized.
    Senator Levin. And passed along to investors.
    Mr. Cathcart. Correct.
    Senator Levin. Now, this high-risk strategy of WaMu, the 
shift from low risk to high risk, was first implemented in 
2004. From 2003 to 2006, subprime originations were up, and 
securitizations were up even more. They had doubled from 2005 
to 2006, according to this chart, and that is based on WaMu's 
statistics. Presumably, that was because WaMu was acquiring 
subprime loans through its subprime conduit or other channels 
or even taking subprime loans from the WaMu portfolio and 
securitizing them. Is that correct?
    Mr. Vanasek. Yes. Washington Mutual purchased subprime 
loans from Ameriquest Mortgage primarily, New Century on 
occasion, and that was a separate pool, separate and distinct 
from Long Beach.
    Senator Levin. All right. Now, Mr. Vanasek, let me start 
with you. Were you aware during your tenure how these Long 
Beach loans and securities that were sold to investors 
performed?
    Mr. Vanasek. To a degree.
    Senator Levin. And what did you understand how they 
performed?
    Mr. Vanasek. They had not performed well as time went on. 
There had always been questions about the underwriting of Long 
Beach mortgages. The company went through, during my tenure, 
three changes in executive management in order to more 
effectively manage the company.
    Senator Levin. At least that was the goal.
    Mr. Vanasek. Yes.
    Senator Levin. Mr. Melby, one of the first audits that you 
oversaw after joining WaMu was an April 2006 audit of Long 
Beach, and that is Exhibit 10,\1\ if you will look in your 
exhibit book. This is entitled ``Memorandum, April 17, 2006,'' 
to the Board of Directors' Audit Committees of Washington 
Mutual. It is from you, and it is regarding ``Long Beach 
Mortgage Company Repurchase Reserve Root Cause Analysis.'' This 
was submitted to the Board's Audit Committee. Is that correct?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 10, which appears in the Appendix on page 408.
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    Mr. Melby. That is correct.
    Senator Levin. And on page 1 at the bottom, it says the 
following: ``LBMC [Long Beach] experienced a dramatic increase 
in early payment defaults.'' Those are EPDs. Do you see that 
about eight lines from the bottom?
    Mr. Melby. Yes, I do.
    Senator Levin. ``LBMC [Long Beach] experienced a dramatic 
increase in EPDs [early payment defaults] during the third 
quarter of 2005,'' it says there, and, ``The early payment 
default recourse provisions of whole loan sales agreements led 
to a large volume of required loan repurchases.''
    Now I am going to say--and you can say if this is 
accurate--that Long Beach ended up repurchasing more than $800 
million in loans, incurring a loss of $100 million. And your 
memo goes on to say at the bottom of page 1 and the top of page 
2 that Long Beach ``did not record an appropriate level of 
repurchase reserves'' for the repurchase obligations and, ``As 
a result, gains on those sales were overstated and not 
corrected until the first quarter of 2006.'' Is that correct?
    Mr. Melby. That is correct.
    Senator Levin. Then on page 2, the first bullet point, 
``Management Control Weaknesses'' were identified by you at 
that first bullet point, which is about two-thirds of the way 
down. ``Relaxed credit guidelines, breakdowns in manual 
underwriting processes, inexperienced subprime personnel, 
coupled with a push to increase loan volume and the lack of an 
automated fraud monitoring tool exacerbated the deterioration 
in loan quality.'' Is that correct?
    Mr. Melby. That is correct.
    Senator Levin. Did the audit find that Long Beach then was 
consistently approving poor loans?
    Mr. Melby. That is a fair assessment.
    Senator Levin. And did it find that Long Beach had weak 
controls over the loan approval process?
    Mr. Melby. Yes.
    Senator Levin. And the push to increase loan volume made 
things worse?
    Mr. Melby. In my opinion, it did.
    Senator Levin. And did you inform senior management of the 
problems?
    Mr. Melby. We did, yes.
    Senator Levin. What was their response?
    Mr. Melby. An action plan was put together, which is part 
of Internal Audit's process and something that--they were 
receptive to the changes. It is something that was monitored on 
a go-forward basis.
    Senator Levin. So they indicated they would make changes.
    Mr. Melby. They did, yes.
    Senator Levin. Mr. Cathcart, look at Exhibit 16,\1\ if you 
would. Now we are at January 2007. This is an email chain at 
the end of December 2006 and beginning of January 2007 between 
you and your colleagues at Washington Mutual about the quality 
of assets at Long Beach. And you write, ``Long Beach represents 
a real problem for WaMu.'' That is the way you start that memo. 
What was the problem that you were identifying at that time?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 16, which appears in the Appendix on page 448.
---------------------------------------------------------------------------
    Mr. Cathcart. I had seen a number of internal audits 
prepared by Randy Melby's group that indicated significant 
control weaknesses. I was seeing reports that indicated poor 
performance of the securitized portion of Long Beach mortgages 
which put us in the lowest quartile of performance. And I 
believed that we had gaps in our controls associated with Long 
Beach.
    Senator Levin. And had there been a surge of loans that had 
to be repurchased as well?
    Mr. Cathcart. There was a surge of loans just after I 
arrived, and I believe that was the $800 million that Mr. Melby 
was just talking about.
    Senator Levin. All right. Now, in 2006, Washington Mutual 
made Long Beach a direct subsidiary of the bank and put it 
under the direct supervision of the Home Loans Division, but 
that did not seem to help. Mr. Melby, take a look at Exhibit 
19.\2\ Your audit team--this is August 20, 2007--issued another 
Long Beach audit report, and it reported a failure to follow 
underwriting guidelines and if you look at Exhibit 19, accurate 
reporting and tracking of exceptions to policy does not exist. 
That is on page 2. Do you see that?
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    \2\ See Exhibit No. 19, which appears in the Appendix on page 462.
---------------------------------------------------------------------------
    Mr. Melby. I do, yes.
    Senator Levin. That is called a high risk to the business 
unit. Is that correct?
    Mr. Melby. That is correct.
    Senator Levin. And in this audit, you also say that when 
credit rules were tight, a Long Beach employee did not always 
comply and instead approved loans that were riskier than the 
bank said it wanted to originate. Is that correct?
    Mr. Melby. That is correct.
    Senator Levin. Now, specialty lending is what Washington 
Mutual called its subprime operations after it abolished Long 
Beach as a separate entity and took over the subprime lending 
function itself, right?
    Mr. Melby. That is correct, yes.
    Senator Levin. Now, wholesale specialty lending was its 
broker-initiated subprime operation, right?
    Mr. Melby. That is my understanding, yes.
    Senator Levin. Mr. Cathcart.
    Mr. Cathcart. Yes, that is correct.
    Senator Levin. Now, if you will look at Exhibit 21,\1\ you 
will see there a review of wholesale specialty lending FPD, 
which is first payment defaults, and that was distributed to 
you, Mr. Cathcart, so presumably you saw that at the time. Is 
that correct?
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    \1\ See Exhibit No. 21, which appears in the Appendix on page 477.
---------------------------------------------------------------------------
    Mr. Cathcart. Yes, it is.
    Senator Levin. It also went to the chairman and chief 
executive officer, Mr. Killinger. Do you see that on the right?
    Mr. Cathcart. Yes, I do.
    Senator Levin. And to Mr. Rotella, Steve Rotella. Do you 
see that on the right?
    Mr. Cathcart. Yes, I do.
    Senator Levin. And to David Schneider.
    Mr. Cathcart. Correct.
    Senator Levin. OK. He was the president of Home Loans at 
that time.
    Now, on page 3 of that report, it identifies two high-risk 
issues, and this is on the top of page 3. Do you see where it 
says that? ``Ineffectiveness of Fraud Detection Tools.''
    Mr. Cathcart. Correct.
    Senator Levin. And ``Weak credit infrastructure impacting 
credit quality,'' do you see that?
    Mr. Cathcart. Yes.
    Senator Levin. And those were high risk?
    Mr. Cathcart. Correct.
    Senator Levin. To the company.
    Mr. Cathcart. Yes.
    Senator Levin. Now, this review that we are looking at--and 
this is, again, Exhibit 21--this review looked at 187 loans 
that had first payment defaults. In other words, the first 
payment was not even made in those 187 loans. I am now reading 
down here on page 3 of this exhibit. One hundred thirty-two of 
the 187 were reviewed, and 115 had confirmed fraud. Do you see 
where that is there?
    Mr. Cathcart. Yes.
    Senator Levin. So 132 sampled were identified with red 
flags, reading from this report, and of that, 115 had confirmed 
fraud, 80 had unreasonable income listed, which means that the 
income that someone said they had was not reasonable for that 
occupation or that person. Is that correct?
    Mr. Cathcart. Correct. There should be a reasonableness 
test when these subprime mortgages are originated.
    Senator Levin. And 80 of these 115--sorry, 80 of the 132 
had unreasonable income. Then it says 133 had evaluation or 
loan decision errors. Do you see that?
    Mr. Cathcart. Yes, I do.
    Senator Levin. Do you see where it says 87 exceeded program 
parameters?
    Mr. Cathcart. Yes.
    Senator Levin. Now, why didn't WaMu clean this up, do you 
know? I mean, this is a report that went right to Mr. 
Killinger. Mr. Rotella and Mr. Schneider received copies of 
this audit. Do you know why this continued, why this was not 
cleaned up at that time?
    Mr. Cathcart. I can only tell you that it was my role as 
chief enterprise risk officer to ensure that both senior 
management and the Board was made aware of these findings and 
that they understood the contents. I cannot speak for 
management actions.
    Senator Levin. All right. Mr. Vanasek, do you want to add 
anything to that? Do you know why they were not cleaned up?
    Mr. Vanasek. No. I was retired by that time.
    Senator Levin. You were retired by then. Mr. Melby.
    Mr. Melby. My response would be similar to Mr. Cathcart's. 
Our job is to report the issues. We do extensive follow-up, and 
we reported up through the Board accordingly.
    Senator Levin. All right. Now, according to this memo, the 
push to increase loan volume made things worse. Is that 
correct?
    Mr. Cathcart. That is correct
    Senator Levin. OK. Now, if you would look at Exhibit 22, 
the problem at WaMu was not confined to Long Beach. Exhibit 
22a.\1\ Now, this is an internal WaMu memo from November 2005 
called ``Southern California Emerging Markets Targeted Loan 
Review Results.'' It says at the top, ``Due to a sustained 
history of confirmed fraud findings over the past three years 
from the Emerging Markets and Retail Broker Program areas, the 
Home Loans Risk Mitigation Team recently conducted a targeted 
review of loans originated in two Southern California Community 
Fulfillment Centers.'' Now, Community Fulfillment Centers are 
WaMu's loan processing offices. Is that correct, Mr. Vanasek?
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    \1\ See Exhibit No. 22a, which appears in the Appendix on page 496.
---------------------------------------------------------------------------
    Mr. Vanasek. Yes.
    Senator Levin. OK. Now, the memo was addressed to you. Do 
you remember the investigation?
    Mr. Vanasek. I do.
    Senator Levin. We are going back here to 2005. The 
investigation focused on two WaMu loan offices called 
Montebello and Downey, and reviewed the loans issued by WaMu 
employees and also loans that were brought to the offices by 
third-party mortgage brokers who were paid a fee when a loan 
that they brought was financed by the bank. Is it correct that 
Montebello and Downey offices were headed by two of WaMu's top 
loan producers and that a lot of loans came out of each of 
those offices, as much as $1 billion in mortgages in a year?
    Mr. Vanasek. Yes, that is correct.
    Senator Levin. And the memo discusses a year-long internal 
investigation that WaMu's own employees conducted into 
suspected fraud affecting loans issued by the Montebello and 
Downey offices, which are referred to as Community Fulfillment 
Centers (CFCs). Among the findings, here is what the memo says, 
in the middle of the page there: `` . . . an extensive level of 
loan fraud exists in the Emerging Markets CFCs, virtually all 
of it stemming from employees in these areas circumventing bank 
policy surrounding loan verification and review . . . 42% of 
the loans reviewed''--and this, again, is in the middle of the 
page--``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.''
    Behind Exhibit 22a is that PowerPoint presentation, Exhibit 
22b,\1\ called ``Retail Fraud Risk Overview,'' and that 
provides a lot of detail about this 2005 investigation, as well 
as Exhibit 23b,\2\ which is an email with data showing that the 
percentage of loans containing fraudulent information at the 
Montebello office was 83 percent and the percentage at the 
Downey office was 58 percent.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 22b, which appears in the Appendix on page 497.
    \2\ See Exhibit No. 23b, which appears in the Appendix on page 511.
---------------------------------------------------------------------------
    So now back to Exhibit 22b. It gives some examples of the 
fraud found. Here is one on page 10 of that memo, ``Fraud Loan 
Samples.'' Here is what that sample says. This is page 10, 
Exhibit 22b, loan number, and it gives the number. 
``Misrepresentation [of] the borrower's identification and 
qualifying information were confirmed in every aspect of this 
file''--misrepresentation, every aspect of this file--
``including Income . . . 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. . . .''
    Mr. Vanasek, those fraud percentages, 83 percent, 58 
percent, those are truly eye-popping numbers, are they not?
    Mr. Vanasek. They are.
    Senator Levin. And the report said that most of the fraud 
was due to willful behavior of WaMu employees. Did that 
surprise you when you read it?
    Mr. Vanasek. No.
    Senator Levin. The memo came out in November 2005. You left 
the bank in December 2005.
    Now, Mr. Melby, you had become auditor a year earlier, in 
December 2004. Were you told about this report?
    Mr. Melby. Not at the time.
    Senator Levin. All right. So you didn't know about this 
report at the time.
    Mr. Melby. At the time, no.
    Senator Levin. Now take a look at Exhibit 22a.
    Let me just ask you, Mr. Vanasek, you said you were not 
surprised at those numbers. As I said, these are really 
unbelievable numbers to an outsider like me, I mean, fraud at 
that level. Why weren't you surprised?
    Mr. Vanasek. There had been long rumors of those offices 
regarding this kind of activity and suspicion about it. Nancy 
Gonseth, the author of this memo, came forward and talked to a 
number of people on my staff. We invited Ms. Gonseth to come to 
Seattle and sit down and see if it moved from the area of 
suspicion to the area of fact, and this report that you see is 
the net result of that discussion. It was forwarded to David 
Schneider, as head of the mortgage lending area, for action. I 
did not have the authority to remove these loan originators.
    Senator Levin. All right. Now, let me just finish this line 
of questioning, and I will turn this over then to you, Senator 
Coburn. I am a little over my 20 minutes, but it is all right. 
I will just finish this one line of questioning.
    Now, in Exhibit 22a, it said that, ``Based on the 
consistent and pervasive pattern of activity among these 
employees, we are recommending firm action be taken. . . .'' 
And no action was taken in 2005. Now, did that surprise you, 
Mr. Vanasek?
    Mr. Vanasek. No.
    Senator Levin. Why not?
    Mr. Vanasek. Because there was this long history of rumor 
and suspicion about these offices. They were high-volume 
producers in low economic areas, so they contributed heavily to 
CRA targets. They were the highest producers, as you have 
indicated, in the company. And in fairness to Mr. Schneider, it 
would take some time for him to investigate and deal with these 
issues. So by the time I left, he had not completed that 
activity.
    Senator Levin. All right. Now, Mr. Cathcart, you started in 
2006 as WaMu's chief risk officer, but were you told at the 
time about this fraud investigation so you could evaluate 
risks?
    Mr. Cathcart. No, I was not.
    Senator Levin. All right. Thank you. Senator Coburn.
    Senator Coburn. Thank you. Kind of continuing along with 
what Senator Levin has started, and I will get back to it in 
detail, Mr. Vanasek, you left in 2005, correct?
    Mr. Vanasek. Correct.
    Senator Coburn. You retired?
    Mr. Vanasek. Yes.
    Senator Coburn. Why did you choose to retire?
    Mr. Vanasek. I had originally agreed with Mr. Killinger 
when I was employed that I would work 6 years with Washington 
Mutual. I was 62 years old. I have a heart condition and four 
cardiac stents. I thought it time for the sake of my health to 
leave.
    Senator Coburn. There is no question in what Senator Levin 
had laid out that there, in several of the offices of WaMu, 
especially in Downey and Montebello, that there was fraudulent 
activity going on, correct?
    Mr. Vanasek. Yes.
    Senator Coburn. I mean, your own internal sources said 
there were fraudulent activity.
    Mr. Vanasek. Right.
    Senator Coburn. By your own audits and your own 
investigation. Was the Board aware of that? Were you ever asked 
to go before the Board, or did you report to the Board? Were 
your reports given to the Board?
    Mr. Vanasek. I gave reports to the Board on a regular basis 
to the Finance Committee. I reported on performance of the 
organization. These kinds of issues were generally handed to 
the audit area and to the business unit for reconciliation or 
resolution. If they were not resolved, then, of course, they 
could be taken to the Board for discussion.
    Senator Coburn. In hindsight, it looks like this was 
systemic activity.
    Mr. Vanasek. Yes.
    Senator Coburn. Would you agree?
    Mr. Vanasek. Yes.
    Senator Coburn. When did you, at any point in time in your 
time as a Risk Manager for them, believe that this was 
widespread fraudulent activity?
    Mr. Vanasek. When Nancy Gonseth came forward with some 
pretty credible material. Prior to that, it had been largely 
rumor.
    Senator Coburn. OK. But you saw it not just as a specific 
one or two offices? Did you think that there was fraudulent 
activity outside of those one or two offices?
    Mr. Vanasek. Yes, Senator. In an organization as large as 
Washington Mutual, with the incentive system constructed as it 
was, that rewarded growth rather than quality, it was 
inevitable that certain people would coach borrowers to meet 
the minimums. They would game the system from time to time. But 
as I indicated in my earlier statement, it was extremely hard 
to catch. Unless you could sit down with the borrower and find 
out what their real income was--and they would, of course, have 
to admit what their real income was--it was hard to tell. You 
could be suspicious on the nature of what kind of occupation 
they might have----
    Senator Coburn. But documentation of income is one of the 
requirements for a mortgage, correct?
    Mr. Vanasek. No. When Washington Mutual moved to a 
substantial number of stated income, that became an even more 
difficult task.
    Senator Coburn. So the policy was you didn't have to prove 
your income? You could just state your income?
    Mr. Vanasek. That is correct.
    Senator Coburn. And that was corporate policy?
    Mr. Vanasek. Yes.
    Senator Coburn. So no proof of income, just a statement of 
income?
    Mr. Vanasek. That is true.
    Senator Coburn. And did that violate any banking or 
mortgage lending rules?
    Mr. Vanasek. Well, it certainly violated old standing 
rules, but it had become very common and highly competitive in 
the industry. And it initially started because people were 
self-employed and it was difficult to get to what their income 
might be. But it broadened beyond self-employed people over 
time and it was a cost efficiency measure.
    Senator Coburn. Mr. Cathcart, did you attend any Board 
meetings to give a perspective on the company's risk profile?
    Mr. Cathcart. Yes, I did.
    Senator Coburn. And how was that received?
    Mr. Cathcart. I reported regularly to the Audit Committee 
and to the Finance Committee during each of their meetings, and 
every 6 months, I gave a full risk report to the full Board of 
Directors. My first report was in the middle of 2006. I think 
it was April 2006. During those meetings, I went through all of 
the risk functions which reported to Enterprise Risk 
Management, starting with credit risk, obviously. But it 
included credit risk, market risk, operational risk, 
compliance, internal audit, which reported to me 
administratively. But I summarized findings in that report. 
Liquidity risks, regulatory relations, which were the groups 
that reported to me. In those reports, I highlighted for the 
Board what I saw at the time and what our group saw at the time 
as the five top risks that the bank was confronting at the time 
of the report.
    Senator Coburn. And were the items that Senator Levin 
highlighted, Exhibits 10 and 22 in terms of this own internal 
look--are you aware that at any time the Board was made aware 
of each of those studies, whether the CEO or others were? Was 
the Board as a whole ever made aware of those studies, that you 
are aware of?
    Mr. Cathcart. I don't recall any reports to the Board that 
highlighted these problems.
    Senator Coburn. Would you think that would be important to 
Board members, to understand that 73 percent or 53 percent of 
the loans didn't qualify even under the loose standards?
    Mr. Cathcart. Yes, Senator, I considered it material. And 
although I wasn't aware of this particular issue, I was 
concerned that the internal Fraud Investigations Group, which 
looked at employee fraud, was not as effective as it could be. 
So during my tenure, after several quarters, I moved that 
group, which at the time reported into the retail part of the 
bank. I moved it under the Chief Internal Auditor, Randy Melby, 
who took over the function. He restaffed it, put a new hire in 
charge, and after that happened, these internal employee fraud 
investigations were picked up, taken up by audit. And as a 
result, that way, I could be very sure the Board was aware of 
the results, which is what happened after that change took 
place.
    Senator Coburn. Were you ever rebuked by the Board for 
giving too pessimistic an outlook in terms of the risks of the 
actions of the mortgage unit?
    Mr. Cathcart. No, I wasn't.
    Senator Coburn. Were there any questions of the Board 
members to you about your assessment of the risk parameters 
that we talked about in terms of what Senator Levin outlined in 
both Exhibit 10 and Exhibit 22?
    Mr. Cathcart. Well, I can recall certainly my first risk 
report to the Board, which was in April 2006, there was no 
discussion.
    Senator Coburn. Is it your feeling, both Mr. Vanasek and 
Mr. Cathcart, that the Board was responsive to the areas of 
concern that you raised?
    Mr. Cathcart. I would say the Board was responsive. The 
Board would continually ask management why progress hadn't been 
made on certain chronic issues which were repeat items from 
both internal audit, credit review, and from the regulators. 
But it appeared as if there was little consequence to these 
problems not being fixed.
    Senator Coburn. OK. Thank you.
    Mr. Vanasek, on Exhibit 78a,\1\ there is an email exchange 
between you and Mr. Killinger where he said, ``I have never 
seen such a high-risk housing market. . . . This typically 
signifies a bubble.'' You responded, ``All the classic signs 
are there.'' Wasn't this email written just months after WaMu 
made a strategic decision to shift to riskier lending?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 78a, which appears in the Appendix on page 790.
---------------------------------------------------------------------------
    Mr. Vanasek. Yes, it was.
    Senator Coburn. How do you account for the fact that 
somebody has seen a bubble, and by definition, a bubble is 
going to burst, and then their corporate strategy is to jump 
into the middle of that bubble?
    Mr. Vanasek. Well, frankly, that is quite hard to answer 
with anything that would satisfy you. I can only say that at 
the point in time, the conventional mortgage, a 30-year 
mortgage, yielded very little, so the company was constantly 
concerned about the reaction of Wall Street to earnings and 
profitability, and therefore pursued these strategies in the 
face of that.
    Senator Coburn. So why was it that a 30-year mortgage was 
yielding poorly as compared to these other high-risk loans? 
What do you make account for the fact that a significant margin 
could not be made in a 30-year loan?
    Mr. Vanasek. It had become a very homogeneous product in 
the market and there was such demand for it that margins shrank 
and it just wasn't very interesting.
    Senator Coburn. Did it have anything to do with the fact 
that the GSEs were the major suppliers of funds for those?
    Mr. Vanasek. I really couldn't answer that. They did bridge 
into Option ARMs and other products over time, but I can't 
speak to their interest in purchasing fixed rate versus 
adjustable rate.
    Senator Coburn. During your time, underwriting standards 
across the industry declined.
    Mr. Vanasek. Right.
    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. Were 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. The problem we had at 
Washington Mutual was the line managers and people like myself, 
members of the Executive Committee, if we were in conflict--let 
us suppose I was in conflict with the head of mortgage lending. 
We had no way to resolve that because the chairman would not 
engage in conflict resolution. He was very conflict-averse.
    So it was left to the two of us to work it out ourselves. 
Sometimes that implied a bit of compromise on my part to allow, 
for example, a small amount of some particular underwriting to 
be done, even though I didn't particularly favor it. In the 
context of a $300 million institution, I tried to limit it to a 
point where it wouldn't be terribly effective, but still 
allowed the line unit to compete. But the absence of pure 
conflict resolution, where I might say, I don't want to do any 
more subprime mortgages versus what the chairman wanted to do 
or the head of mortgage wanted to do, there was no way to 
resolve it.
    Senator Coburn. At any time in your thinking prior to your 
retirement, did you see some of the handwriting on the wall for 
the direction WaMu was going?
    Mr. Vanasek. Well, as indicated by my earlier statement, at 
the end of 2004, and I believe that is the correct date, I sat 
down with the chairman and made a one-on-one, which I found to 
be the most effective way to reach him, impassioned argument to 
stand up and take an industry-leading position. I thought he 
could stand out as the leading mortgage executive if he could 
blow a whistle and say, enough is enough. The deterioration in 
mortgage underwriting has gone too far and we at Washington 
Mutual will not participate any further.
    Senator Coburn. You mentioned earlier the Community 
Reinvestment Act (CRA) and you correlated it with the two areas 
that Senator Levin had noted that were high, actually 
fraudulent mortgage applications. Do you think that WaMu's 
decisions, especially in these two areas, were more likely 
related to getting the points up on the CRA versus just too 
good sales or agents that were closing loans and brokering 
loans?
    Mr. Vanasek. I don't think CRA led or forced WaMu into 
doing a great deal more low-income moderate housing, moderate-
income lending. It had a small influence. But the real 
influence was the pure profitability of subprime lending.
    Senator Coburn. Right, the up-front profitability.
    Mr. Vanasek. Correct.
    Senator Coburn. Make the loans, package the loans, sell the 
loans, collect the money, with a small residual for WaMu in 
terms of risk.
    Mr. Vanasek. And some subprime mortgage loans purchased 
from others, namely Ameriquest, were retained on the balance 
sheet. They tended to be higher quality subprime loans and they 
were monitored very closely. I held quarterly business reviews 
with every business unit reviewing their delinquencies and 
growth and changes in policies and so forth in an effort to 
maintain control of the growth.
    Senator Coburn. So basically, you were buying higher-
quality subprime loans from competitors than what you were 
selling into the market?
    Mr. Vanasek. Correct.
    Senator Coburn. You and Mr. Cathcart both had mentioned the 
impact of the rating agencies. Just honestly, do you think the 
rating agencies were accurate, did a fair job, or were part of 
the problem?
    Mr. Vanasek. I think they were very much a part of the 
problem. If you read Michael Lewis's book, as I understand you 
have, you will understand exactly how that worked. They sold, 
or they rated securities based on average FICO scores, credit 
scores. Everyone in the business knows that you can barbell a 
securitization in such a fashion to put 50 percent good loans 
and 50 percent higher-risk subprime loans in and you are still 
going to take an unbelievable beating.
    Senator Coburn. Mr. Cathcart, your comments on that?
    Mr. Cathcart. I would agree that the rating agencies played 
a significant part in the outsized nature of the securitization 
market. The ratings--first of all, the incentives, I think, are 
inappropriate where the issuers pay for the rating. Second of 
all, the models that were brought to----
    Senator Levin. Are you saying it is inappropriate?
    Mr. Cathcart. Inappropriate that the issuer should pay the 
rating agency to rate the issuer's paper. It seems to me the 
investor should be paying for it if they are looking for third-
party verification.
    The simplistic models that were used, maybe as a matter of 
convenience, which didn't take in the so-called black swan 
events that if you are looking at a AAA paper you really need 
to look at because models are not going to give you the level 
of confidence necessary for a AAA paper at 99.9 percent, 
whatever percent is required, probability of non-default.
    The volumes were so significant and the opportunities to 
make money that I would have expected that shortcuts were being 
taken as part of just getting these securitizations out into 
the market as quickly as possible.
    The overcomplexity of a number of these products, some of 
the more absurd examples, such as the CDOs-cubed and securities 
like that, which where I have read a number of very in-depth 
research papers that try and evaluate the tiered risk of these 
securitizations and it is almost, frankly, impossible to figure 
it out.
    That is just a cluster of factors. And I would add, not 
wanting to take too much time, the over-dependence or over-
reliance on the rating agencies by government regulatory 
bodies, even to the tune of bank regulations allowing, for 
example, AAA securities to be held as risk-free assets on the 
bank's balance sheet. This gives more credence to the rating 
agencies than they should have and it absolves financial 
institutions from having to make their own independent risk 
assessments when they load their balance sheets up with 
securities.
    Senator Coburn. This is for Mr. Vanasek and Mr. Cathcart 
again. It is true that risk management employees reported both 
to each of you and also other senior business executives. Was 
there a line around you in management with the people that 
worked for you?
    Mr. Cathcart. Could you clarify----
    Mr. Vanasek. Yes.
    Senator Coburn. I am just wondering if the people that 
worked for you in risk management had a way around you to 
senior executives, or did it all go through you?
    Mr. Vanasek. It all went through me.
    Senator Coburn. And there was nothing around you?
    Mr. Cathcart. That was not the case in my situation. There 
was a way around me.
    Senator Coburn. Explain that to us if you would, please.
    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 of 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.
    Senator Coburn. And this is a hard question to answer, but 
I hope you will make an attempt to do it. Was there a point in 
time when you recognized the writing on the wall in terms of 
the fraudulent activity? Mr. Vanasek, you saw a bubble coming, 
and Mr. Cathcart, I am not sure that we have any comments from 
you. But was there a point in time when you knew that things 
were going to come unwound?
    Mr. Cathcart. Well, it is the old image of boiling a frog. 
It happened gradually. I think if we had all been paying 
attention, we all would have realized it began in Q3 of 2006, 
when HSBC had the big write-downs on subprime, which we at the 
time attributed to poor integration with Household Financial. 
As it turns out, that was the thin edge of the wedge. And I 
would say it is fair to say that I didn't realize that was the 
beginning of it.
    I would also say that there was an ingrained belief, and I 
certainly shared it, that the house prices in the country would 
not reduce simultaneously because they had not----
    Senator Coburn. In other words, there would be a 
geographical difference?
    Mr. Cathcart. There would be a geographical difference. And 
so the biggest concern I had was the overconcentration of 
Washington Mutual's portfolio in California----
    Senator Coburn. Florida and California.
    Mr. Cathcart [continuing]. Florida, as well--where I did 
believe there was a significant risk because my belief was that 
a regional meltdown was possible.
    But I would say that it wasn't really until probably the 
second quarter of 2007 when liquidity started drying up, and I 
understood what that meant to the portfolio, that I realized 
that we were in significant difficulty. The drying up of 
liquidity, not just because the bank itself might have 
difficulty funding itself, but more importantly, the market for 
the mortgages which, if you think about Washington Mutual as a 
large manufacturer, a huge machine, the supply is very 
difficult to slow down and the market for the supply was drying 
up very quickly, and that resulted in all of the mortgages that 
had previously been warehoused for sale having to go on the 
balance sheet. So what I foresaw was stress on capital and, of 
course, the whole implications of bringing all those mortgages 
onto the balance sheet.
    Senator Coburn. Mr. Vanasek.
    Mr. Vanasek. Senator, I would have answered the question 
somewhat differently. I realized by 2004 that the industry was 
in some degree of difficulty. Obviously, I didn't know then and 
I didn't foresee the magnitude of the difficulty. I didn't see 
the broad-based failure in financial institutions to the degree 
that they subsequently unfolded. But it was clear to me that 
the practices were fundamentally unsound, and it couldn't go on 
forever. We had housing prices increasing much more rapidly 
than incomes and you knew that ultimately there was a limit to 
this. It just practically could not go on. So that was part of 
my 2004, in effect, urgent message to management that we needed 
to drop these practices and become more conservative at that 
point in time.
    Senator Coburn. And unfortunately, they did not heed that 
advice.
    Mr. Vanasek. Correct.
    Senator Coburn. In the viewpoint of packaging loans to be 
resold, what was the attitude inside WaMu in terms of--
everybody knew they had a lot of poor loans. I mean, all this 
data we have collected. Yet WaMu was still packaging loans and 
the rating agencies were still giving them AAA--credit rating 
agencies. What was the attitude? You could package as much junk 
as you want and still get a AAA rating and move it out the 
door? What was the culture that said we can keep doing this 
even though we know we are selling a product that is not worth 
the paper it is written on?
    Mr. Vanasek. I would suggest you need to address that 
question to Mr. Beck and Mr. Schneider, who were responsible on 
the credit side. We were not responsible for selecting 
mortgages that would go into pools. We had no part in that 
whatsoever.
    Senator Coburn. But you did see it happening?
    Mr. Vanasek. We did see large volumes of mortgage-backed 
securities being created----
    Senator Coburn. Right.
    Mr. Vanasek [continuing]. And it was viewed as a profit 
center in the Washington Mutual Capital Corp. But I didn't know 
or didn't see that they were being selective in terms of what 
was going in versus what was not going in.
    Senator Coburn. All right. Mr. Cathcart, any comments on 
that?
    Mr. Cathcart. Well, I would agree that as a Chief Risk 
Officer, I didn't participate in the selection process and had 
understood that these were almost pari passu type selections, 
in other words, randomly sampled portfolios, and if that isn't 
the case, that would surprise me. I think there was a belief 
that the rating agencies, if the rating agencies were able to--
and I wasn't part of the process, but if the rating agencies 
were satisfied with the tranching of the securitization, then 
it would satisfy the market. But I would agree with Mr. Vanasek 
that the question is properly directed at the group that sold 
the portfolios.
    Senator Coburn. All right. Thank you. Thank you, Mr. 
Chairman. I would ask unanimous consent for Senator Collins' 
opening statement to be placed in the record.\1\
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    \1\ The prepared statement of Senator Collins appears in the 
Appendix on page 132.
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    Senator Levin. Thank you very much for that. It will be 
made part of the record. Senator Kaufman.
    Senator Kaufman. Thank you, Mr. Chairman, and thank you for 
holding this incredibly important hearing at an incredibly 
important time.
    Mr. Vanasek, you mentioned in your opening statement that 
you thought the repeal of Glass-Steagall was a big mistake. 
Could you kind of expand on why you thought that was a big 
mistake?
    Mr. Vanasek. Yes. I think when you create a situation like 
Washington Mutual Capital Corporation, you encourage the very 
question that just was asked of me. I also thought that perhaps 
the talent was not sufficiently available for all of the 
companies that suddenly started creating mortgage-backed 
securities and filling the marketplace.
    Senator Kaufman. And this may be above your pay grade. What 
would you think about reinstituting that in light of what 
happened?
    Mr. Vanasek. I think certainly I am not an expert on Glass-
Steagall, but I think certainly elements of it deserve to be 
considered.
    Senator Kaufman. Thank you. You mentioned about FICO 
scores, and I understand you don't do the individual mortgages 
and you are not familiar with the section in The Big Short 
where he talks about in horrifying detail, how FICO scores were 
just used.
    Mr. Vanasek. Yes.
    Senator Kaufman. Can you comment on how FICO scores were 
used at Washington Mutual?
    Mr. Vanasek. Yes. FICO scores were the best single 
indicators we had in terms of predicting default or successful 
underwriting. We moved more and more to FICO scores over time 
because of what was happening with conventional underwriting, 
where we would have in the past looked at either tax returns or 
pay stubs or other things we would have looked at, we would 
have had different kinds of appraisals. They wouldn't have been 
drive-by appraisals. It would have been full appraisals, and so 
forth. So in the absence of those more detailed forms of 
underwriting and analysis, we had relied more heavily on FICO.
    Senator Kaufman. And the barbelling you were talking about, 
do you think that went on?
    Mr. Vanasek. I am sure that it went on. It was evidenced 
thoroughly in the book that certain packagers of mortgages did 
that and then the rating agencies would take and pool them and 
rate 80 percent of them AAA, even though the individual 
mortgages were nowhere near AAA.
    Senator Kaufman. And do you think it went on at Washington 
Mutual?
    Mr. Vanasek. I can't answer that. I don't, again, know the 
selection process that went into the pools.
    Senator Kaufman. Where that went on, how would you 
characterize that behavior? I mean, is that just kind of the 
rules of the road, let the buyer beware, caveat emptor?
    Mr. Vanasek. I think it was gaming the rating agencies.
    Senator Kaufman. Gaming, meaning----
    Mr. Vanasek. Meaning that they knew how the ratings 
agencies were putting these ratings on the pools and so long as 
that was the case, they didn't see any problem with putting low 
FICO score mortgages in with high FICO score mortgages if they 
could still get the AAA rating.
    Senator Kaufman. But then you had to wrap these mortgages 
up and get them into mortgage-backed securities and sell them 
to people. I mean, was there any requirement that you disclose 
that you were using this technique to get around the rating 
agencies?
    Mr. Vanasek. I don't believe there was. I believe the 
rating agencies--their job was to look at the distribution of 
FICO scores within those mortgages and I am not sure that they 
did it.
    Senator Kaufman. Yes, but I am just saying, now we get past 
them. They are doing it. We have gotten around them. We have 
figured a way to get around them. But then we actually take the 
securities with the rating agencies and we are giving them out 
to the people who are purchasing the mortgage-backed 
securities. Now, I think they would assume, not just because a 
rating agency said it, but it would seem to me that Washington 
Mutual kind of said that this was not being arranged in a 
deceptive way.
    Is that fair to--I mean, what is the responsibility to the 
people? OK, the rating agencies, we know they failed their 
responsibility. What is the responsibility to Washington Mutual 
when it sells mortgage-backed securities to disclose to the 
folks that buy them that this is how we go about business? I 
understand the rating agencies failed theirs. What about 
Washington Mutual's responsibility?
    Mr. Vanasek. I think we had a responsibility to share with 
them the distribution of FICO scores and other characteristics 
of the mortgages in a full disclosure environment.
    Senator Kaufman. Mr. Cathcart, what do you think?
    Mr. Cathcart. I am not familiar with the disclosure rules 
surrounding the securitizations and didn't participate in the 
selection or the disclosure.
    Senator Kaufman. All right.
    Mr. Cathcart. But I would like to pick up on something that 
Mr. Vanasek said concerning FICO scores. There were two things 
that happened with respect to FICO scores. There was definitely 
an overdependence on them, but under the surface, the bank had 
changed the way it originated. Banks changed the way they were 
originating loans, which I think is what Mr. Vanasek already 
said.
    But the second change was the customer behavior also 
changed and we had a phenomenon which we had never seen before, 
which was that a buyer who bought a house that ended up being 
so-called underwater, where the house was worth less than the 
mortgage, actually stopped making payments. We first saw this 
in 2006, and what resulted is when you looked at the 
delinquency rates for a population of borrowers, you found that 
the high FICO score borrowers were delinquent at exactly the 
same rate as the low FICO score borrowers, which in theory was 
impossible. So it had the whole industry scratching its head. 
That phenomenon appeared about Q4 of 2006.
    In retrospect, what became clear was that in the past, 
borrowers would have first let their credit cards go and the 
very last asset that they allowed to go delinquent was their 
home. This time around, it literally went in reverse, where it 
was deteriorating housing prices that caused the mortgage to go 
delinquent and the credit cards were preserved. And we actually 
saw that phenomenon in our credit card portfolio, where we 
found that people who didn't own houses had performance that 
did not deteriorate in the earlier stages of the cycle, whereas 
people who owned homes deteriorated. And that was completely 
counterintuitive.
    So these sorts of changes, when you throw them into an 
environment where there is an overdependence on FICO, results 
in really basically steering with the lights out.
    Senator Kaufman. Mr. Melby, do you have any comments on 
that, FICO scores?
    Mr. Melby. I have nothing more to add.
    Senator Kaufman. And asking, Mr. Cathcart, in The Big 
Short, which we have all read, to our alarm, they said a FICO 
score in light of your comment that low FICO scores were being 
delinquent as high as higher, in his book, he says a FICO score 
of 550 was virtually certain to default and should never have 
been lent money in the first place. Is that an overstatement or 
is that really--when you say low and high, were you talking 
about, like, 550?
    Mr. Cathcart. Five-fifty is extremely low----
    Senator Kaufman. Right.
    Mr. Cathcart [continuing]. And the only way to--that would 
definitely be subprime, probably deep subprime. There are ways 
to lend into that market that involve such techniques as 
calling the borrower the day before the loan is due, keeping 
track of them, almost handling them by hand.
    Senator Kaufman. But what really was happening, what 
Michael Lewis says, is they were taking the 550s and throwing 
them in to get an average that passed the rating game, 
realizing that the 550s are going to fail and there wasn't 
going to be anybody calling them on the phone and holding their 
hand, right? Is that fair to say?
    Mr. Cathcart. If the right collections and management 
procedures aren't in place, that loan will default with high 
probability.
    Senator Kaufman. Right. If we did this in any other 
business and then sold it to somebody like we sold the 
mortgage-backed securities, that would be fraud. I mean, 
essentially, if you did this, if a car company did it, they got 
five cars, junkers and good ones, and put them together and 
sold them at the auction market, they would be called back and 
say, you can't do that. Mr. Vanasek.
    Mr. Vanasek. I agree.
    Senator Kaufman. Mr. Vanasek, we have talked about the 
rating agencies and we have talked about the people inside 
WaMu. How would you characterize the behavior of the bank 
regulators during this whole period? And then, Mr. Cathcart, I 
am going to ask you when you took over for Mr. Vanasek how you 
would characterize the bank regulators.
    Mr. Vanasek. I am very pleased that you asked me that 
question because my opinion is that the OTS Examiner-in-Charge 
during the period of time in which I was involved--his name is 
Lawrence Carter--did an excellent job of finding and raising 
the issues. Likewise, I found good performance from Steve 
Funaro, the FDIC Examiner-in-Charge. They were both there the 
entire time that I was there.
    What I cannot explain is why the superiors in the agencies 
didn't take a tougher tone with the banks given the degree of 
findings, negative findings. My experience with the OTS, versus 
with the OCC, was completely different. So there seemed to be a 
tolerance there or a political influence on senior management 
of those agencies that prevented them from taking a more active 
stance. By a more active stance, I mean putting the banks under 
letters of agreement and forcing change.
    Senator Kaufman. Mr. Cathcart.
    Mr. Cathcart. Well, I, like Mr. Vanasek, 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, and 
I would agree that the 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 than I had expected with the 
other--than I had seen with the other two regulators. I would 
say the relationship was good, but in the case of Long Beach 
Mortgage, for example, in my experience, regulators would have 
closed that channel down if management hadn't much earlier than 
the OTS was prepared to.
    Senator Kaufman. For both of you, wouldn't one explanation 
be that the people at the very top as the agencies had a self-
regulatory attitude? As a matter of fact, the Securities and 
Exchange Commission, at the very top, Alan Greenspan, we should 
be self-regulating. I mean, as opposed to a political thing 
that somehow someone is getting a political deal because they 
know someone. I know that is way above your pay grade--which of 
those seem more compelling as an excuse for the fact?
    Mr. Cathcart. I wouldn't characterize it as an excuse, but 
I would say that the OTS did believe in self-regulation.
    Senator Kaufman. Mr. Vanasek.
    Mr. Vanasek. I think you have to look at the fact that 
Washington Mutual made up a substantial portion of the assets 
of the OTS and one wonders if the continuation of the agency 
would have existed had Washington Mutual failed. So I think 
they had a very strong mutual interest in the company 
succeeding.
    Senator Kaufman. Thank you. Mr. Cathcart, Mr. Vanasek 
talked about a stated income loan. Can you give us your 
definition of a stated income loan?
    Mr. Cathcart. A stated income loan is one where the loan 
consultant asks the person how much they make and they enter 
that onto the credit application.
    Senator Kaufman. And there is no further follow-up of that 
number?
    Mr. Cathcart. Correct.
    Senator Kaufman. When was that developed? I guess it was 
during your period, Mr. Vanasek, is that right?
    Mr. Vanasek. It preceded me by some period of time, but it 
became a higher percentage of the loans over time as it became 
more market acceptable.
    Senator Kaufman. And Mr. Cathcart, why do you think stated 
income loans became a higher percentage of the loans that were 
being originated?
    Mr. Cathcart. Well, as Mr. Vanasek said, it 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.
    Senator Kaufman. Right.
    Mr. Cathcart. 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 with in the portfolio.
    Senator Kaufman. Mr. Vanasek, how far up the management 
chain in Washington Mutual do you think they are aware that the 
percentage of stated loan incomes that people were engaging in, 
what Mr. Cathcart said, and that more and more this is becoming 
a way to get around the rules in order to package as many 
mortgages as possible to then sell off in mortgage-backed 
securities?
    Mr. Vanasek. I have to believe that given the long-term 
experience of the executives that they knew.
    Senator Kaufman. Mr. Cathcart.
    Mr. Cathcart. I would say that all of the review functions 
were identifying that as a risk issue and that, therefore, both 
senior management and the Board were aware.
    Senator Kaufman. Mr. Melby.
    Mr. Melby. I would agree.
    Senator Kaufman. What size mortgages could you get stated 
income on? Could it go on in any mortgage that Washington 
Mutual offered, do you know?
    Mr. Vanasek. I am not aware of any particular limit that 
existed, but I could be incorrect.
    Mr. Cathcart. I do not recall the guidelines. I believe 
stated income was a carve-out of the entire population so there 
were certain prequalifications in place that would allow the 
offering of a stated income loan. But I do not have any details 
associated with that.
    Senator Kaufman. Mr. Vanasek, do you think when a stated 
income loan was resold, do you think the prospectus disclosed 
that, in fact, the loan was made without verification of a 
borrower's income?
    Mr. Vanasek. Well, again, Mr. Beck would probably be the 
best source for that, but the indications were that it may have 
been in the prospectus. Whether anyone paid attention to all of 
the detail in the prospectus, I do not know.
    Senator Kaufman. Mr. Cathcart.
    Mr. Cathcart. I am not familiar with the offering 
memoranda, but I would say that stated income loans were a 
market standard of sorts, and it would not surprise me that 
buyers were aware that stated income loans were in the 
portfolio.
    Senator Kaufman. Mr. Melby, do you have anything to add on 
this?
    Mr. Melby. I have nothing to add.
    Senator Kaufman. Mr. Melby, do you think the line managers 
knew that loan originators were knowingly sponsoring mortgage 
applications that contained lies?
    Mr. Melby. I think the answer is yes. We had certainly 
picked that up in several of our investigation reports through 
discussions, through our independent investigation work.
    Senator Kaufman. And do you think middle managers also knew 
that?
    Mr. Melby. That information was communicated via the 
results of that work.
    Senator Kaufman. And how about the top managers?
    Mr. Melby. The memos were also communicated upward.
    Senator Kaufman. Do you have any idea what the reaction was 
to that?
    Mr. Melby. Concerned. The specific investigation I am 
referring to goes back to--Senator Levin had referred to a 
request by an insurance agency relative to fraud, and so we had 
conducted an investigation back in--the report was issued in 
2008. Those results were very telling from the standpoint that 
we had this pattern of conduct that had been occurring for a 
period of years where limited or no action had been taken. So a 
report was addressed again up through executive management and 
up through the board.
    Senator Kaufman. This sounds suspiciously like fraud. I 
mean, if you know that you are selling a product that is not 
truthful--I guess is this just caveat emptor, or is this 
something that could be considered, let us say, poor business 
practice?
    Mr. Melby. Concerning, to say the least, yes.
    Senator Kaufman. Mr. Cathcart.
    Mr. Cathcart. I cannot comment on that.
    Senator Kaufman. OK. Well, do you think that you are 
knowledgeable of the fact that there were people at the--the 
line managers knew that loan originators were knowingly 
sponsoring mortgages that had untruths in it, did you know 
that?
    Mr. Cathcart. I probably cannot speak to line managers. I 
can speak to what Mr. Melby just referred to, which is the 
reports that went to senior management and the Board.
    Senator Kaufman. Right. And those did spell out what was 
going on in terms of----
    Mr. Cathcart. They identified the problems that we have 
talked about and based on statistically representative samples 
taken from the origination factor.
    Senator Kaufman. Mr. Vanasek.
    Mr. Vanasek. Historically, Washington Mutual, in comparison 
to other banks that I worked for, was administratively weak, 
and it did not carry the same priority, in other organizations 
that I worked for. Randy and I both work for Norwest, any 
suspicion of fraud would have resulted in immediate 
terminations.
    Senator Kaufman. Yes, they are administratively weak. Do 
you think based on the presentation up here of how emphasis was 
made on subprime loans, how they are more profitable, do you 
really think that if, in fact, the company had been losing 
money because of administration that it would have been just as 
weak administratively? Do you think if they were reporting the 
fact that we were, not doing enough loans, do you think that 
would have been administered poorly? I mean, it is one thing to 
say it is administered poorly, it is another when it is an 
incredible advantage to you, to your compensation program, to 
everything you are doing, to continue to administer poorly. How 
much of that do you think----
    Mr. Vanasek. Senator, in all due respect, I cannot 
speculate on the motivations of these senior managers. All I 
can say is it was not addressed thoroughly and promptly in the 
fashion that I was accustomed to seeing.
    Senator Kaufman. Mr. Cathcart, do you have the same 
opinion, that it was not addressed in a timely manner based on 
the number of examples that were being reported to the top of 
the company, that there was, in fact, fraud going on at the 
lower levels on the origination forms?
    Mr. Cathcart. I would agree it was not responded to 
appropriately, and I would also agree with Mr. Vanasek's 
comment that Washington Mutual was unusual in the fact that it 
allowed these gaps to continue for as long as it did.
    Senator Kaufman. All right. Mr. Melby.
    Mr. Melby. I would agree with those comments.
    Senator Kaufman. I guess that is all the questions I have, 
Mr. Chairman.
    Senator Levin. Thank you very much, Senator Kaufman.
    Let me just pick up on that comment of yours, Mr. Melby, 
about the allegations going to the Board in 2008, allegations 
of fraud. This is Exhibit 24,\1\ which I think you were 
referring to. We have seen the earlier reports showing 
extensive fraud in applications. We have seen that they were 
not acted upon, and now we have a report going to the Board on 
April 4, 2008. I think this is probably what you were referring 
to, Mr. Melby, when you said that the report on the subject of 
fraud went to the Board in 2008. Is that correct?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 24, which appears in the Appendix on page 515.
---------------------------------------------------------------------------
    Mr. Melby. Yes, that is correct.
    Senator Levin. On page 3 of this memo, Exhibit 24, right 
there in the middle, it says that the ``2005 and 2007 reviews 
found high levels of misrepresentation and suspected loan fraud 
for this [office] (62% of the 2007 sampled loans).'' That was 
the same office, in other words--the events of 2007 were 
covered in the 2008 report that we are looking at. Those high 
fraud levels continued. This is the same office, again, that 
had 83 percent in the earlier audit, right?
    Mr. Melby. Correct.
    Senator Levin. Now, what was your reaction, Mr. Melby, to 
the fraud finding in this 2008 report that another 
investigation 2 years earlier had found similar results?
    Mr. Melby. Well, this was a series of questions that had 
been asked of me. This is the report and the work that we had 
done that simply pulled it all together. So the previous work 
done by the Risk Mitigation Group within Home Loans back in 
2005, subsequent samples being tested in late 2005 all the way 
through 2007, it was clear there was a pattern of conduct with 
the same fraud findings were occurring which led us to 
certainly conclude that action had not been taken.
    Senator Levin. All right. Now, were you appalled, 
basically, when you found that action had not been taken during 
this period?
    Mr. Melby. I was deeply concerned to the point where there 
was no question that this had to be escalated up to the Audit 
Committee.
    Senator Levin. All right. What was the reaction now? You 
talked to senior managers, I believe Mr. Killinger, Mr. 
Rotella--is that correct?--about this.
    Mr. Melby. That is correct.
    Senator Levin. And what was their reaction?
    Mr. Melby. It has been a while. Certainly concerned, but I 
do not have an explanation for you as to a response as to why 
this was not addressed. Again, we reported the facts, and our 
job was to make certain that we had action on it this time 
going forward.
    Senator Levin. And when you talked to--I take it you talked 
with Mr. Schneider as well?
    Mr. Melby. On this report, yes.
    Senator Levin. What was his reaction?
    Mr. Melby. Mr. Schneider was certainly concerned with the 
issues. Mr. Schneider had some concerns with some of the 
accuracy, I think, of some of the issues in the report. We 
vetted those issues and felt we had done a thorough job and 
stood by the results of our work.
    Senator Levin. So he disputed some of the facts.
    Mr. Melby. We did not sit down specifically and talk. I 
know Mr. Schneider had some concerns with some of the issues, 
but for the most part did not dispute the overall results of 
the report.
    Senator Levin. On page 2 of this exhibit, the second bullet 
point there, it says that Home Loans Risk Mitigation 
``generated alerts that identified patterns of fraudulent loan 
practices and provided remediation recommendations that were 
not acted upon by [Home Loans] Senior Management. Employee 
interviews conducted during this investigation consistently 
described an environment where production volume rather than 
quality and corporate stewardship were the incented focus.''
    Then if you go back again on page 3, if you look at that 
bullet point at the top of page 3 of that exhibit, it says 
there that, ``Loan Producers were compensated for 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.'' It says there that, ``Employee 
interviews conducted during this investigation consistently 
described an environment where production volume rather than 
quality and corporate stewardship were the incented focus.''
    How did senior management, Mr. Melby, react to the finding 
that compensation incentives put loan speed and volume over 
loan quality?
    Mr. Melby. I do not recollect a specific discussion around 
that other than we had concluded and made our conclusion just 
drawing on what we felt was a preponderance of evidence over 
the prior 2 years based on other internal reports as well as 
our own interviews with employees.
    Senator Levin. Mr. Cathcart, what was your reaction to this 
2008 report? Were you surprised basically that nothing had been 
done following the 2005 investigation?
    Mr. Cathcart. I do not recall this report. It happened 
shortly before I left.
    Senator Levin. All right. Appendix B in this report, near 
the top it says, ``Outside of training sessions that Risk 
Mitigation conducted in late 2005, there was little evidence 
that any of the recommended strategies were followed or that 
recommendations were operationalized.'' Do you see that?
    Mr. Melby. Yes.
    Senator Levin. OK. How does a bank that turns out loans of 
which 58 or 62 or 83 percent contain misrepresentations or 
fraudulent borrower information, how does a bank operate that 
way and expect that there is going to be any confidence in the 
loans that it is issuing? In other words, how does it claim to 
be a reliable institution with these kind of numbers, Mr. 
Vanasek?
    Mr. Vanasek. Well, it is very difficult, obviously. If you 
will permit me, Senator, a short story. Earlier on in my career 
at the bank, I conducted three meetings with groups of 
underwriters in the mortgage area at three different locations, 
and I asked them one simple question: Can you make the 
decisions that you arrive at hold? And the answer was 
universally no, because the loans were always escalated up, so 
if they declined a loan, it was escalated to a higher level, a 
marketing manager who would ultimately approve. That was part 
of the environment.
    Senator Levin. Basically they did not want to slow down 
loan production.
    Mr. Vanasek. Correct.
    Senator Levin. It was too profitable, and it would have 
gone to a competitor. Is that basically the problem?
    Mr. Vanasek. Correct.
    Senator Levin. And the other question that is raised, 
though, by this exhibit is whether or not investors who bought 
these loans needed to be notified of the fraud. And if you look 
at both the bottom of page 3 and the bottom of page 4, it 
raises the question, since there was such a significant amount 
of it in those particular areas, that the investors who bought 
them might need legally to be notified.
    Mr. Vanasek. If the seller knows there is fraud, I think 
they are compelled to reveal it.
    Senator Levin. Now, the fraud problem is not limited to 
Montebello and Downey. Take a look at Exhibit 30,\1\ if you all 
would. This is a WaMu document called ``Significant Incident 
Notification.'' It is dated April 1, 2008, about loans that 
were issued in 2007 by another WaMu retail loan office called 
Westlake Village, which is near Los Angeles.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 30, which appears in the Appendix on page 544.
---------------------------------------------------------------------------
    The first bullet point in Exhibit 30 says, ``Many of the 
loans had several fraud findings such as fabricated asset 
statements, altered statements, income misrepresentation and 
one altered statement that is believed to have been used in two 
separate loans.''
    Third bullet point. ``One Sales Associate admitted that 
during that crunch time some of the Associates''--some of the 
associates--``would `manufacture' asset statements from 
previous loan documents and submit them to the [Loan 
Fulfillment Center]. She said the pressure was tremendous from 
the LFC to get them the docs since the loan had already been 
funded and pressure from the Loan Consultants to get the loans 
funded.''
    The next bullet says that loan consultants ``did not 
instruct them to falsify documentation and just told them to 
get the loans funded with whatever it took.'' ``Whatever it 
took.''
    Exhibit 31,\1\ if you take a look at that. That memo 
summarizes the same investigation. It says that, ``Sales 
Associates would take [asset] statements from other files and 
cut and paste the current borrower's name and address.''
---------------------------------------------------------------------------
    \1\ See Exhibit No. 31, which appears in the Appendix on page 546.
---------------------------------------------------------------------------
    Mr. Cathcart and Mr. Melby, were you informed about this 
investigation at the Westlake Village office? Did you know 
about it, Mr. Cathcart?
    Mr. Cathcart. I was aware of it based on this 
correspondence, yes.
    Senator Levin. You were aware of it at the time?
    Mr. Cathcart. This email is me being informed of this.
    Senator Levin. All right. Mr. Melby.
    Mr. Melby. Yes, the Investigation Group reported to me, so 
I was aware.
    Senator Levin. Now, do you know if that loan officer was 
held accountable in any way? Do you have any knowledge of that?
    Mr. Melby. No, I do not. Senator, my understanding on this, 
we did a lot of investigation reports. It is my opinion--I 
think that this individual was terminated.
    Senator Levin. I think, though, that they were offered a 
job within the bank before they left. I think they left the 
bank but were offered jobs. Do you know if I am wrong on that?
    Mr. Melby. I am not aware of that.
    Senator Levin. OK. Now, banks that find out about high 
rates of fraud affecting their loans and then do not do 
anything about them is emblematic of how banks contributed to 
the financial crisis, putting short-term profits first, letting 
deep-seated problems responsible for poor loan quality fester, 
churning out and selling billions of dollars of defective-
quality loans, and it all helped poison our financial system 
with toxic mortgages.
    I have some additional questions, but we have a 10-minute 
round on this one, so I will turn it back to Dr. Coburn and 
then come back for a third round.
    Senator Coburn. I have one serious question, and you can 
answer it one of two ways, one inside or one being outside. If 
you were an investor in Washington Mutual and you knew what was 
going on, would you consider that as being a material adverse 
risk factor from Washington Mutual?
    Mr. Vanasek. Yes
    Senator Coburn. Mr. Cathcart.
    Mr. Cathcart. When you say what was going on, I am----
    Senator Coburn. Well, I am talking about the fraud, from 
Westlake to all these others, the idea that the incentive was 
paying people to get loans done whether they were qualified or 
not. Nobody knows exactly what percentage of the portfolio of 
loans they were making were in that category, but it was a 
significant number, everybody would agree. Would you consider 
that a material adverse condition for Washington Mutual?
    Mr. Cathcart. I cannot really comment because it sounds 
like a technical term, and I am not----
    Senator Coburn. Well, it is a very clear term. It is an SEC 
requirement that if, in fact, a company has a material adverse 
effect on it, it is required to report it.
    Mr. Cathcart. I probably would have to speak to the 
auditors of the company to define what a significant deficiency 
was. It sounds as if it would be a disclosable event.
    Senator Coburn. Well, think about it if you were a 
shareholder only, would you consider this to be a material 
adverse impact on your ownership?
    Mr. Cathcart. If I were a shareholder in a bank that I 
became aware had big problems of fraud in its origination 
process, I would not want to own the shares of that bank.
    Senator Coburn. That is right. You would want to be 
notified.
    Mr. Cathcart. Yes.
    Senator Coburn. All right. Mr. Melby.
    Mr. Melby. I would state it the same way. I would need a 
clearer definition of adverse material misstatement, but as a 
shareholder, obviously very concerning, and I would again, like 
Mr. Cathcart, probably would not own shares of that 
organization.
    Senator Coburn. Let me ask you a follow-up question, each 
of you, and this probably does not apply to Mr. Vanasek because 
he was not there at the time. Was senior management, upper-
level management, aware of these problems, in your opinion?
    Mr. Cathcart. Yes, I would say senior management was aware.
    Senator Coburn. Mr. Melby.
    Mr. Melby. Yes.
    Senator Coburn. All right. Thank you. I have no other 
questions, Mr. Chairman.
    Senator Levin. Mr. Melby, take a look, if you would, at 
Exhibit 34.\1\ This is a September 8, 2008, report from the 
Corporate Credit Review group. I think this review is not part 
of your audit team, but a copy of the report was sent to your 
staff, Debbie Dahl-Amundson. Is that correct?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 34, which appears in the Appendix on page 564.
---------------------------------------------------------------------------
    Mr. Melby. Debbie Dahl-Amundson.
    Senator Levin. She is on your staff?
    Mr. Melby. Yes.
    Senator Levin. She was on your staff. Now, this internal 
investigation found that WaMu loans marked as containing 
fraudulent information were nonetheless being sold to 
investors. This is a very significant issue.
    Page 3, first bullet point. Here is what it says in that 
first bullet point near the top: ``Of the 25 loans tested, 11 
reflected a sale date after the completion of the investigation 
which confirmed fraud.'' It goes on to say, ``There is evidence 
that this control weakness has existed for some time.'' First 
of all, that is a heck of a way of describing selling 
securities which contain fraudulent mortgages as a control 
weakness, but we will let that euphemism stand there for a 
moment. The important part is that it existed for some time, 
this failure.
    Eleven of 25 loans tested reflected a sale date after 
completion of the investigation which confirmed fraud.
    Now, this is all serious business, but I have got to tell 
you, it gets doubly serious when you get into this area, after 
fraud is found, nonetheless a security containing that 
fraudulent mortgage is still put on the market.
    Now, the executive summary at the top of this report, 
which, according to its front page, went to Mr. Rotella and Mr. 
Schneider, as well as to you, Mr. Melby, this page 2 says the 
following: ``The overall system of credit risk management 
activities and processes exhibits weakness and/or has 
deficiencies related to multiple business activities. Exposure 
is considerable and immediate corrective action is essential in 
order to limit or avoid considerable losses, reputation damage, 
or financial statement errors. Repeat findings, if any, are 
significant.''
    So it looks like to me that there was not sufficient 
interest at WaMu to fix the shoddy lending practices. As long 
as Wall Street had a big enough appetite for junk mortgages, 
WaMu would just dump defective loans into the pool of commerce 
and just hope that they would be diluted and that nobody would 
notice.
    Again, I do not know if you have a comment on this, but we 
would welcome it. First, Mr. Melby, do you have a comment on 
this? Do you remember receiving this?
    Mr. Melby. I do. I remember receiving the report, and, 
again, this was written by the Corporate Credit Review group. 
My only reaction would be to the first bullet regarding your 
comment earlier about the control weaknesses existed for some 
time. In my view, this is the same issue that has been reported 
not only by Risk Mitigation but, again, in our reports as well.
    Senator Levin. Mr. Cathcart, do you have any comment on 
this?
    Mr. Cathcart. Well, this report was obviously written 6 
months after I left, but I can certainly understand the 
language. ``Repeat findings, if any, are significant'' is-- and 
``requires improvement rating'' is really the only tool that 
this team and risk management had to be able to bring senior 
management's attention to these problems.
    Senator Levin. I have a number of questions that I will 
have to withhold asking because of the time issue here. But 
basically I would refer in terms of how this higher-risk 
lending strategy came into existence, Exhibit 2a,\1\ which is a 
January 2005 presentation to the Finance Committee of the Board 
of Directors about the higher-risk lending strategy. Page B1.2 
says, ``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.'' It then tasked the Corporate 
Credit Risk Management ``to develop a framework for execution 
of the strategy.''
---------------------------------------------------------------------------
    \1\ See Exhibit No. 2a, which appears in the Appendix on page 229.
---------------------------------------------------------------------------
    Mr. Vanasek, did you get necessary institutional support to 
effectively manage the credit risk that is inherent in a 
higher-risk lending strategy such as that? Did you get 
institutional support to carry out this kind of a higher-risk 
strategy?
    Mr. Vanasek. I would have to say no, Senator, in the sense 
that we wanted to impose strict limits in terms of the dollar 
amounts of various types of loans being made. We found that to 
be very difficult to do. So there were continuing issues here 
about the strategy versus the opinion of the credit risk area.
    Senator Levin. Now, on page B1.4 of that Exhibit 2a, there 
is a definition of higher-risk lending. It says it consists of 
``Consumer Loans to Higher Risk Borrowers,'' including subprime 
loans, single-family residential, and consumer loans to 
borrowers ``with low credit scores at origination.'' In the 
footnote, it says that means FICO scores under 660.
    Did WaMu, not just Long Beach but did WaMu issue loans to 
borrowers with FICO scores under 660? Do you know, Mr. Vanasek?
    Mr. Vanasek. Yes, they did, and again, that was a sort of 
thing you wish to limit highly. The only reason to do that 
would be to meet a CRA requirement. There was a debate in the 
industry, Senator, about what constituted subprime. It used to 
be that anything below 660 was considered--a FICO score of 660 
was considered subprime, and the industry seemed to adopt the 
660 limit. So it was, again, evidence of the overall 
deterioration going on.
    Senator Levin. Now, we have put in these exhibits, Exhibit 
1i.\1\ This is based on data on loan originations from WaMu's 
Securities and Exchange filings from 2004 to 2008. What these 
numbers show is that in 2003, fixed mortgages, the traditional 
mortgages, make up about two-thirds of WaMu's loan 
originations, and that percentage shrank every year until 2007, 
when they accounted for only one-quarter of the loans that WaMu 
originated. Meanwhile, higher-risk mortgages, including Option 
ARMs, home equity, and subprime loans, increased from one-third 
of the mortgages in 2003 to three-quarters of the mortgages by 
2007.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 1i, which appears in the Appendix on page 223.
---------------------------------------------------------------------------
    Do those figures reflect the implementation of the strategy 
of moving to higher-risk loans, would you say?
    Mr. Vanasek. I would say, yes.
    Senator Levin. During these years, WaMu cut back on its 
loan originations overall, but while cutting back, it also 
changed the mix from lower- to higher-risk loans, as indicated 
in that strategy. Is that correct?
    Mr. Vanasek. Yes, correct.
    Senator Levin. I want to ask just another quick question 
about the Option ARM to both you, Mr. Vanasek and Mr. Cathcart, 
as risk managers. Did you have concerns about the Option ARM?
    Mr. Vanasek. Yes, we had concerns from the standpoint of 
the 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 lost payments in 
the 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.
    Senator Levin. And Mr. Cathcart, did you have concerns?
    Mr. Cathcart. Well, I would say there was a lot of focus 
and concern on disclosure issues. In other words, ensuring that 
when the product was sold, that the customer understood the 
product, and a great deal of focus between the regulators and 
the bank took place on that front.
    As far as the structure of the product itself is concerned, 
the criteria associated with origination were supposed to be 
sufficiently strong, meaning the borrowers were supposed to be 
sufficiently strong that the negative amortization was not 
considered to be a key issue. Of course, I had concerns about 
it, because negative amortization is intuitively counter to 
what standard risk appetite would suggest, but I would say the 
portfolio had performed very well, and in retrospect, was 
overly dependent on the continued appreciation in house prices.
    Senator Levin. And when WaMu qualified a borrower for an 
Option ARM loan, did the bank use the payment that the borrower 
would have to make at a recast or did they use a lower payment?
    Mr. Cathcart. It used the lower rate, Mr. Chairman.
    Senator Levin. All right. Would you agree with that, Mr. 
Vanasek?
    Mr. Vanasek. Yes.
    Senator Levin. Was there a high risk in doing that?
    Mr. Vanasek. Yes.
    Senator Levin. And is it true that, as shown in Exhibit 
37,\1\ page 7 of that exhibit--at times, 95 percent of WaMu's 
Option ARM borrowers were making minimum payments, which led to 
no or negative amortization? Are you able to find that quickly?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 37, which appears in the Appendix on page 591.
---------------------------------------------------------------------------
    Mr. Vanasek. Yes, I found it, Mr. Chairman.
    Senator Levin. OK. Does that strike you as being accurate?
    Mr. Vanasek. Yes, it does.
    Senator Levin. Thank you. Dr. Coburn.
    Senator Coburn. I have one last question for Mr. Cathcart. 
If you will go to Exhibit 64,\2\ this is the 2007 performance 
review for the Head Risk Manager of the Home Loans Division of 
WaMu and you are listed as one of the reviewers. Many banks try 
to isolate the risk managers from sales pressures. But at WaMu, 
the first performance goal for the Home Loans Risk Manager, 
which represents 35 percent of the evaluation, is growth. Under 
growth, it is specified, achieve net income, $340 million. 
Sales targets are laid out. Home equity is $18 billion. 
Subprime is $32 billion. Option ARM is $33 billion. Alt A is 
$10 billion.
---------------------------------------------------------------------------
    \2\ See Exhibit No. 64, which appears in the Appendix on page 750.
---------------------------------------------------------------------------
    The second performance goal is risk management, which is 
worth only 25 percent of the valuation, and I would remind you 
this is for the Head Risk Manager of the Home Loans Division. 
Am I reading this performance review correctly, that the Home 
Loans Risk Manager was instructed to put achieving net income 
growth targets above risk management, and did you agree with 
those performance goals?
    Mr. Cathcart. Yes, Senator, you are reading it correctly. 
No, I didn't.
    Senator Coburn. OK. Was her compensation tied to the 
results of a performance review?
    Mr. Cathcart. Yes, it was.
    Senator Coburn. Does it strike you as strange that the 
performance goals for the head of risk management is small risk 
management but sales volume and profit?
    Mr. Cathcart. Yes, it does.
    Senator Coburn. All right. Thank you. I have no other 
questions.
    Senator Levin. Thank you. Senator Kaufman.
    Senator Kaufman. No questions.
    Senator Levin. Are you all set? We thank you all. It has 
been a long panel, but the other ones will be equally long, if 
that gives you any comfort. We are going to try to work here. I 
am not sure whether we will take a break for lunch or not. We 
will have to kind of play that by ear. But you are all excused. 
Thank you.
    Mr. Cathcart. Thank you, Mr. Chairman.
    Senator Levin. We will now move to our second panel of 
witnesses, David Schneider, former President of Home Loans of 
Washington Mutual Bank, and David Beck, former Division Head of 
Capital Markets of Washington Mutual Bank.
    First, let me extend our appreciation for both of you being 
with us today. We look forward to your testimony, and as I 
indicated to the previous panel and to all panels, all of the 
witnesses that testify before this Subcommittee by our rules 
are required to be sworn. So at this time, I would ask you both 
please to stand and to raise your right hand.
    Do you swear that the testimony you are about to give to 
this Subcommittee will be the truth, the whole truth, and 
nothing but the truth, so help you, God?
    Mr. Schneider. I do.
    Mr. Beck. I do.
    Senator Levin. Thank you. We are going to again use the 
timing system, where one minute before the red light comes on, 
you will see lights change from green to yellow. It gives you 
an opportunity to conclude your remarks. Your full written 
testimony will be printed in the record in its entirety. Please 
limit your oral testimony to no more than 5 minutes.
    Mr. Schneider, please go first, followed by Mr. Beck, and 
then we will proceed to questions. Mr. Schneider.

   TESTIMONY OF DAVID SCHNEIDER,\1\ FORMER PRESIDENT OF HOME 
                 LOANS, WASHINGTON MUTUAL BANK

    Mr. Schneider. Chairman Levin, Dr. Coburn, and Members of 
the Subcommittee, thank you for the opportunity to appear 
before you today. My name is David Schneider.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Schneider appears in the Appendix 
on page 158.
---------------------------------------------------------------------------
    Beginning in July 2005, I served as President of Washington 
Mutual's Home Loan Business, which originated prime mortgage 
loans. In 2006, I was given the additional responsibility for 
Long Beach Mortgage Company, which was WaMu's subprime lending 
channel.
    Before I arrived at WaMu, its management and Board had 
adopted a lending strategy for the coming years. I understood 
that its strategy was intended, at least in part, to reduce 
WaMu's exposure to market risk, that is, its exposure to 
interest rate changes. WaMu planned to do so by shifting the 
assets it held on its balance sheet away from market risk 
towards credit risk, for example, by holding more adjustable-
rate mortgages. This strategy was called a higher-risk lending 
strategy and would have been implemented through the bank's 
Asset and Liability Committee. ALCO made decisions on which 
loans to hold and which to sell based on the loans' risk-return 
profile and other relevant issues, including the type and 
geographic location of the loans WaMu already had on its books.
    Although WaMu intended to change its business strategy, 
market conditions soon caused WaMu to go in another direction. 
As house 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. WaMu increased documentation requirements, raised 
minimum FICO scores, lowered LTV ratios, and curtailed 
underwriting exceptions. My team also enhanced WaMu's fraud 
detection programs.
    During my time at WaMu, we reduced and then entirely 
stopped making Alt A loans and Option ARM loans. Alt A lending 
ended in 2007. Option ARM loans decreased by more than a half 
from 2005 to 2006, and by another third from 2006 to 2007. WaMu 
stopped offering Option ARM loans altogether at the beginning 
of 2008.
    When the subprime lending operation at Long Beach was 
placed under my supervision in 2006, I was asked to address the 
challenges its business presented. During that year, I changed 
Long Beach management twice. As I became more familiar with 
Long Beach Mortgage, I concluded that its lending parameters 
should be tightened, so across various loan products we raised 
FICO scores, lowered LTV ratios, established maximum loan 
values, increased documentation requirements, improved programs 
to detect and prevent fraud, and in 2007 eliminated stated 
income lending. As a result, the percentage of approved Long 
Beach loans that were based on full documentation increased 
every year I oversaw Long Beach, and the percentage of loans 
with combined LTV ratios greater than 90 percent decreased 
every year over that same period.
    More broadly, WaMu eliminated many subprime products and 
then stopped originating subprime loans entirely. As a result, 
WaMu's subprime lending declined by a third from 2005 to 2006 
and by 80 percent from 2006 to 2007.
    When I began my job at Washington Mutual, my goal was to 
evaluate and improve our home lending efforts in all respects. 
As market changes began to change, my team and I worked very 
hard to adapt to the new conditions and at the same time 
address the challenges WaMu faced. During the time I was 
President of Home Loans, we acted to reduce the size and 
associated risk of the Home Loans business. Specifically, we 
closed its broker and correspondent lending channels. We closed 
Long Beach Mortgage. We eliminated a number of higher-risk loan 
products and bolstered quality controls through tightening 
credit standards, improving the automated underwriting tools, 
enhancing fraud detection and prevention, and curtailing 
underwriting exceptions.
    I hope this brief summary has been helpful and I look 
forward to your questions. Thank you.
    Senator Levin. Thank you very much, Mr. Schneider. Mr. 
Beck.

  TESTIMONY OF DAVID BECK,\1\ FORMER DIVISION HEAD OF CAPITAL 
                MARKETS, WASHINGTON MUTUAL BANK

    Mr. Beck. Chairman Levin, Dr. Coburn, and Members of the 
Subcommittee, my name is David Beck. From April 2003 through 
September 2008, I worked at Washington Mutual Bank. In early 
2005, I received responsibility for the capital markets 
organization in Washington Mutual's Home Loans Group. In the 
second half of 2006, as part of Mr. Schneider's changes to the 
management at Long Beach Mortgage, I was given responsibility 
for Long Beach's capital markets organization. I will use these 
brief remarks to highlight a few aspects of WaMu's capital 
markets organizations.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Beck appears in the Appendix on 
page 163.
---------------------------------------------------------------------------
    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 these 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. The 
portfolio managers making the investment decision for these 
institutional investors typically had long-term hands-on 
experience creating, selling, or buying mortgage-backed 
securities. In addition, purchasers had extensive information 
regarding the loans WaMu sold, including the data on the 
performance of similar loans and the conditions in the housing 
market.
    WaMu also bought and sold home loans. WaMu Capital Corp. 
negotiated the terms and helped to close the whole loan sales 
undertaken by whichever WaMu entity owned the loans. Typically, 
these were sales of WaMu-originated loans, although on occasion 
WaMu Capital Corp. did sell loans originated by third parties.
    Washington Mutual Mortgage Securities Corp. also operated a 
bulk loan conduit through which it purchased loans that were 
then pooled into securitization transactions. WaMu Capital 
Corp. would underwrite securitization transactions in the same 
manner, regardless of whether the loans were originated by WaMu 
or a third party.
    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.
    Your invitation asked specifically about the Repurchase and 
Recovery Team. In general, purchasers of loans can, under 
certain circumstances, demand that the seller repurchase a 
loan. While the circumstances in which a repurchase may be 
required are dictated by contractual and legal considerations, 
the repurchase process itself usually involves a give-and-take 
between buyer and seller. Buyers often take an expansive view 
when the seller is obligated to repurchase a loan and sellers 
often disagree. Perhaps not surprisingly, these negotiations 
lead to outcomes that vary from loan to loan and transaction to 
transaction. Occasionally, it is the seller that identifies 
problems with a loan in the first instance and initiates the 
repurchase process without demand from the buyer.
    Toward the end of 2007, the WaMu group responsible for 
evaluating and responding to repurchase requests was placed 
under my direction. That group reviewed repurchase requests to 
determine if they presented valid grounds for repurchase of a 
loan at issue. When appropriate, the group also made repurchase 
demands to those financial institutions from which WaMu had 
acquired loans.
    The group, which came to be called the Repurchase and 
Recovery Team, also created a computer modeling process to 
identify loans which WaMu had sold that might present a 
repurchase obligation. When this process identified loans that 
presented a repurchase obligation, the repurchase team would 
affirmatively approach buyers to notify them of that 
conclusion. In this way, WaMu took proactive action to address 
potential repurchase obligations.
    I hope that this very brief introduction has been helpful 
to the Subcommittee and I would be happy to answer any 
questions that you may have. Thank you.
    Senator Levin. Thank you very much, Mr. Beck.
    We will have rounds of 10 minutes this time, and we will 
have more than one round.
    Mr. Schneider, the gain on sale numbers for the various 
kinds of loans were based on WaMu's own data. If you look at 
Exhibit 3,\1\ which is an April 18, 2006, presentation that you 
put together for the WaMu Board of Directors about the high-
risk lending strategy, you will see that on page 5 is a chart 
entitled, ``Shift to High Margin Products.'' On the left of 
that chart is information about the gain on sale which is 
produced by the higher-risk loans. We have enlarged that part 
of the chart so that you can see it better. It shows that WaMu 
earned about 19 basis points for a fixed loan, a traditional 
loan, while Option ARMs earned 109, home equity loans earned 
113 basis points, and subprime loans earned 150 basis points, 
about eight times more than the fixed loans.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 3, which appears in the Appendix on page 278.
---------------------------------------------------------------------------
    Is it fair to say that the gain on sale for the subprime 
loans was much higher than fixed loans because the bank was 
able to charge higher fees and interest rates? Is that 
basically the case? Mr. Schneider.
    Mr. Schneider. Thank you, Senator. If you look at the gain 
on sale, there are a number of factors that would have driven 
what would be the ultimate gain on sale. Fixed tended to have a 
fairly low gain on sale because it was a highly commoditized 
product that generally went to Fannie Mae and Freddie Mac. 
Subprime tended to have a large gain on sale, A, because of the 
additional credit risk that investors would demand from the 
product, and B, because it was probably less competitive than--
--
    Senator Levin. Does that mean higher interest rates?
    Mr. Schneider. Yes, sir.
    Senator Levin. OK. And Option ARMs?
    Mr. Schneider. Option ARMs would have higher gain on sale 
primarily because of the--it has relative to fixed. It had less 
competition. And most of the interest rate risk remained with 
the borrower. Therefore, for banks' balance sheets and 
investors' balance sheets, it was a more attractive asset to 
hold.
    Senator Levin. So that was a higher interest rate there, as 
well?
    Mr. Schneider. No, not necessarily.
    Senator Levin. Not on the Option ARMs?
    Mr. Schneider. No, sir.
    Senator Levin. OK. After it was recast, was it a higher 
interest rate then than it was on fixed?
    Mr. Schneider. It would depend on the rate environment, Mr. 
Chairman.
    Senator Levin. OK. Now, there was a big appetite for 
residential mortgages on Wall Street until September 2007, is 
that true?
    Mr. Schneider. Yes. It was around the summer of 2007 when 
volume--when securitization started to----
    Senator Levin. Until then, there was a huge appetite, is 
that fair to say, for residential mortgages on Wall Street?
    Mr. Schneider. I would say the appetite was fairly 
significant. We started to see some diminishing appetite in 
late 2006 and the middle of 2007.
    Senator Levin. OK. What are daily rate sheets?
    Mr. Schneider. Daily rate sheets, Mr. Chairman, would be 
what we would post each day for the price of the mortgages we 
were offering on that particular day.
    Senator Levin. OK. Maybe I should ask Mr. Beck this 
question. So the daily rate sheets were basically put together 
by the Capital Markets Group, and these folks were where, New 
York or Seattle?
    Mr. Beck. The daily rate sheets were distributed from 
Seattle. The information that went into the rate sheets could 
have come from both New York and Seattle.
    Senator Levin. OK. Was Wall Street playing basically the 
biggest role in setting the prices for the nonconforming loans 
across the country?
    Mr. Beck. For non-agency mortgages, the rate sheets relied 
on the execution from Wall Street, yes.
    Senator Levin. So basically, those----
    Mr. Beck. As opposed to, say, Fannie or Freddie.
    Senator Levin. Right.
    Mr. Beck. Yes.
    Senator Levin. OK. Mr. Schneider, in your opening 
statement, your written statement, you described Long Beach as 
having challenges that you were asked to address. What were 
they?
    Mr. Schneider. Senator, Mr. Chairman, when I first got to 
Long Beach, I also saw that audit report that Mr. Melby had put 
together and we took over the next several months, implemented 
a number of steps to improve the way originations were 
operated. We put into place advanced fraud tools. I changed 
management twice, Mr. Chairman, and then over the course of 
time also eliminated a number of exceptions, eliminated some of 
the high-risk products and ultimately decided at the end, in 
the middle of 2007, that Long Beach was an operation that we 
should shut down.
    Senator Levin. And the audit that you saw when you first 
got there, that 2006 audit, which is Exhibit 10,\1\ was the 
reason, as I understand it, that you were asked to take 
responsibility for Long Beach, is that correct?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 10, which appears in the Appendix on page 408.
---------------------------------------------------------------------------
    Mr. Schneider. I actually took responsibility for Long 
Beach at the beginning of 2006 and one of the primary drivers 
was the increase in repurchase demands that Long Beach had 
experienced, and that was the first area that we looked at.
    Senator Levin. Then you saw the audit?
    Mr. Schneider. Correct.
    Senator Levin. Then you ordered a crackdown on early 
payment defaults at Long Beach, is that correct?
    Mr. Schneider. That is correct.
    Senator Levin. Then they surged again a year later when you 
wrote Exhibit 13,\2\ a December 2006 email to your colleagues, 
``Short story is this is not good. . . . we 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.'' That is Exhibit 13a. Does 
that sound familiar?
---------------------------------------------------------------------------
    \2\ See Exhibit No. 13a, which appears in the Appendix on page 418.
---------------------------------------------------------------------------
    Mr. Schneider. Yes, it does.
    Senator Levin. All right. Eight months later, in an August 
20, 2007 audit report--that is Exhibit 19--here is what you 
said.\3\ ``Repeat Issue--Underwriting guidelines established to 
mitigate the risk of unsound underwriting decisions are not 
always followed . . . accurate reporting and tracking of 
exceptions to policy does not exist. . . .'' Do you see that?
---------------------------------------------------------------------------
    \3\ See Exhibit No. 19, which appears in the Appendix on page 462.
---------------------------------------------------------------------------
    Mr. Schneider. What page are you on, Mr. Chairman?
    Senator Levin. That is on page 3, repeat issue. Do you see 
that at the top? High risk.
    Mr. Schneider. Yes, I do.
    Senator Levin. ``Repeat Issue--Underwriting guidelines 
established to mitigate the risk of unsound underwriting 
decisions are not always followed. . . .'' Then it says that is 
high risk. The next one, high risk, ``accurate reporting and 
tracking of exceptions to policy does not exist. . . .'' So do 
you see that now?
    Mr. Schneider. I do.
    Senator Levin. All right. So Long Beach was continuing to 
issue poor quality loans, is that fair to say?
    Mr. Schneider. I think it is fair to say, Mr. Chairman, 
that the underwriting group and the audit group, as well as 
myself, were less than satisfied with the progress being made, 
which is the reason we ultimately decided to shut down the 
operation.
    Senator Levin. Yes. When did you finally shut it down and 
transfer it to WaMu?
    Mr. Schneider. It was shut down--when Long Beach was shut 
down, we stopped originating subprime mortgages through 
brokers, which was the business that Long Beach did. I think 
that was third quarter of 2007.
    Senator Levin. OK. Now, the vast majority of Long Beach 
mortgages, your data shows about 95 percent were sold or 
securitized. Exhibit 1c,\1\ if you will look at it, is based on 
WaMu data. The Long Beach Mortgage annual securitizations 
increased more than tenfold, from $2.5 billion in the year 2000 
to more than $29 billion in the year 2006. From 2000 to 2007, 
Long Beach and WaMu together securitized $77 billion in 
subprime mortgages, producing mortgage-backed securities. Now, 
those are the securitization numbers. This is WaMu's own 
summary of its subprime securitizations as of June 2008.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 1c, which appears in the Appendix on page 214.
---------------------------------------------------------------------------
    So Long Beach and WaMu's subprime securitizations doubled 
from 2005 to 2006, going from $14 to $29 billion. Long Beach at 
the same time was cutting back on loan originations during 
2006, which means that WaMu was purchasing subprime loans from 
other lenders and mortgage brokers through its conduit and 
other channels. Is that right so far? Are you with me so far?
    Mr. Schneider. Yes, Senator. I think if you look at that 
chart up there, that shows securitizations. There were also a 
number of whole loan sales done in 2005. I am not sure of the 
exact numbers. And the other----
    Senator Levin. Those are based on your numbers. Do you have 
any problem with the numbers you see there in terms of 
securitizations?
    Mr. Schneider. In terms of securitizations, I do not.
    Senator Levin. OK. Now, why were so many Long Beach 
mortgages defaulted? Why were Long Beach securities 
consistently among the worst performing in the marketplace?
    Mr. Schneider. Senator, I don't have that market data in 
front of me.
    Senator Levin. Well, but you know that they were 
consistently among the worst performing securities in the 
marketplace. Those mortgages which were made part of those 
securities, you know that.
    Mr. Schneider. If you look at the performance of Long 
Beach, I don't think any of us were happy with the 
performance----
    Senator Levin. No, not happy, but they were among the worst 
performing. Why is it true? Why was that true?
    Mr. Schneider. I think that is primarily true because Long 
Beach tended to originate higher credit risk assets than other 
subprime mortgage originators.
    Senator Levin. All right. Now, it stopped issuing the 
securitizations in 2003 while it worked on correcting the 
problems, is that correct?
    Mr. Schneider. I am sorry. I didn't hear the question.
    Senator Levin. When WaMu discovered that Long Beach was 
issuing a large number of loans that violated its own credit 
policies, it stopped securitizations in 2003 to correct the 
problems, to give it a chance to correct the problems, is that 
correct?
    Mr. Schneider. That is my understanding. I wasn't----
    Senator Levin. Why weren't securitizations halted in 2005, 
2006, and 2007 when similar underwriting problems were 
uncovered? That is my question.
    Mr. Schneider. Senator, I wasn't there in 2003. I don't 
know what the----
    Senator Levin. No, I am saying why wasn't it stopped in 
2005, 2006, and 2007?
    Mr. Schneider. I think as we looked at the originations and 
the overall quality coming out, we felt that there was--we were 
given the right disclosures and that if loans proved to be 
fraudulent or have a problem, we would be buying them--we would 
buy them back out.
    Senator Levin. Dr. Coburn.
    Senator Coburn. Thank you.
    Would you put up the percentage chart on WaMu project 
originations and purchases by percentage.\1\ In fairness to 
your testimony in terms of the declining nature, however, this 
pie chart represents, in fact, the percentages of the 
originations of WaMu as a percentage. Based on your testimony, 
what we see is something very different, what actually happened 
versus what you said, because you can see that each year, fixed 
mortgages go down and non-conforming loans still are 
increasing, versus your testimony that said that was not the 
case, that when you came on board, things started to change.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 1i, which appears in the Appendix on page 223.
---------------------------------------------------------------------------
    So two questions for that. Did things change because you 
all made an active process to change, or was the market souring 
so much that you couldn't market those loans?
    Mr. Schneider. If you look at the charts there, those are 
percentages there and----
    Senator Coburn. Right. They are percentages.
    Mr. Schneider [continuing]. The aggregate volumes went down 
significantly. Some of the items I focused on were subprime. I 
took over subprime in 2006. It was 16 percent of the volume at 
that time. By the time we got to 2007, it was 5 percent on a 
very small base. Option ARMs declined from 22 percent to 18 
percent during the time I was there, and by the time we got to 
2008, Option ARMs were zero. And then the other ARM product 
would be more conventional hybrid ARMs, so those would be loans 
that would be sold to Fannie Mae and Freddie Mac.
    Senator Coburn. Would you put up the WaMu origination and 
purchases by loan type, 2003 to 2007. So not only were the 
percentages declining, but the absolute dollars----
    Mr. Schneider. Yes.
    Senator Coburn [continuing]. Were declining. And why was 
that?
    Mr. Schneider. As we addressed the Home Loans business from 
2005 until 2008, I think there was a general consensus that the 
size of the mortgage business was too large relative to the 
size of the bank. We wanted to help bring that size of the 
aggregate business down. We closed a number of sites, actually 
reduced the employment level of Home Loans by probably 50 
percent during that time.
    Senator Coburn. Mr. Chairman, I would like to add, 
Washington Mutual's executive summary that was put forth,\2\ 
and we will have it available as part of our Fannie Mae 
alliance and Freddie Mac business relationship proposal. And I 
am sorry you don't have this in front of you, but one of the 
things it said is the key to the proposal is it provides 
significant liquidity for 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.
---------------------------------------------------------------------------
    \2\ See Exhibit No. 34, which appears in the Appendix on page 564.
---------------------------------------------------------------------------
    Between 2000 and 2008, Washington Mutual sold more than 
$500 billion in loans to Fannie Mae and Freddie Mac. How did 
that affect Washington Mutual's bottom line?
    Mr. Schneider. Senator Coburn, I can only really speak to 
the time I was there in 2005 to 2008. We were going through 
some very difficult challenges. I think the home loans business 
was losing money for most of that time period and we were 
working aggressively to see if we could help remedy that.
    Senator Coburn. All right. How important was the 
relationship with Freddie Mac in the bank's decision to Option 
ARMs? Would you have been optioning ARMs if Freddie Mac hadn't 
been there?
    Mr. Schneider. Yes. Washington Mutual, Senator, had 
originated Option ARMs for years. I think it provided another 
source of liquidity for the company to sell its Option ARMs by 
having Freddie Mac buy them.
    Senator Coburn. OK. So they were sold for years to Freddie 
Mac, right? Had Freddie Mac not been there, would there have 
been a market in the last 2 years that you were--the last 2 
years before you wound this all down, outside of Freddie Mac?
    Mr. Schneider. There would have been.
    Senator Coburn. Would it have been as advantageous as the 
relationship with Freddie Mac?
    Mr. Schneider. I am not sure of the specific economics.
    Senator Coburn. Can you look at Exhibit 4,\1\ the 
presentation, ``Way2Go! Be Bold!'' Are you familiar with this 
PowerPoint presentation?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 4, which appears in the Appendix on page 290.
---------------------------------------------------------------------------
    Mr. Schneider. I am.
    Senator Coburn. When and where did you give this 
presentation?
    Mr. Schneider. I don't know the specifics. If I recall 
correctly, this presentation was given a number of times, so I 
would have given it to folks in staff functions. I would have 
given the presentation to sales and operating functions, as 
well, so----
    Senator Coburn. Anybody above you that you would have given 
it to?
    Mr. Schneider. I might have shown it to Mr. Rotella or Mr. 
Killinger.
    Senator Coburn. What did you intend be bold?
    Mr. Schneider. This was done in, I think, early 2007. We 
had gone through a very difficult time, and quite honestly, I 
was just trying to help improve the morale of the Home Loans 
business, which was feeling--I think everyone was feeling badly 
about what was happening.
    Senator Coburn. On the second page of the presentation, 
there is a slide of an organizational chart that has the 
caption, ``We are all in sales.'' Were you ever concerned that 
heavy emphasis on sales with no oversight risk management was 
problematic?
    Mr. Schneider. Senator, this presentation was meant to be 
taken as a holistic view, and what I meant by we were all in 
sales was just my way of saying we all have to serve the 
customer. We all have to help the customer achieve their needs 
and help them in whatever way we can. So that means we all have 
a part in helping the customer.
    Senator Coburn. OK. In your testimony, you made a point of 
saying that the decision to make Long Beach a subsidiary of 
WaMu was made before you got there. Do you think that it was a 
mistake to bring Long Beach into WaMu?
    Mr. Schneider. Senator, I don't know the specifics of why 
that decision was made or----
    Senator Coburn. No, I didn't ask you the specifics. I said, 
do you think it was a mistake to bring Long Beach into WaMu? Is 
that yes or no?
    Mr. Schneider. Yes. I would say no, because it was still a 
part of the holding company, so we had----
    Senator Coburn. You had all the obligations----
    Mr. Schneider [continuing]. All the obligations anyway.
    Senator Coburn. All right.
    Mr. Beck, were you made aware ever during your time at WMCC 
that the loans underlying WaMu Securities were having problems?
    Mr. Beck. I knew that we had underwriting problems, yes.
    Senator Coburn. Who were the most common customers for 
Washington Mutual's mortgage-backed securities?
    Mr. Beck. Hedge funds, pension funds, insurance companies, 
corporations.
    Senator Coburn. OK. Do you believe that your customers had 
a full sense of what they were buying when they purchased these 
securities?
    Mr. Beck. I do.
    Senator Coburn. So you think they were aware of the risk?
    Mr. Beck. I do.
    Senator Coburn. OK. If you had to redo anything relating to 
securitizing mortgages, how would you do it differently?
    Mr. Beck. I would securitize mortgages with more full 
documentation. I think the underlying documentation was an 
important aspect of the performance of the loans.
    Senator Coburn. All right. Were you aware as you 
securitized these loans of the significant problems in the 
credit risk side of the business in terms of what they were 
seeing in terms of loan originations?
    Mr. Beck. No, I was not with respect to some of the audit 
reports that were referred to in the first testimonies.
    Senator Coburn. Did it surprise you, that up to 82 percent 
in certain offices were for unqualified, undocumented loans?
    Mr. Beck. Those are high numbers, but as I looked at that 
document, I did see that those were taken from an adverse 
sample from that loan origination center. So those loans had 
already been identified as risky. They were either first 
payment or early payment defaults, and of those first payment 
and early payment defaults, I would expect that there would be 
a high percentage of problems.
    Senator Coburn. OK. You have said under Exhibit 50 that 
Long Beach paper was the ``worst performing paper'' in 2006.\1\ 
How were you made aware of these problems?
---------------------------------------------------------------------------
    \1\ See Exhibit No. 50, which appears in the Appendix on page 670.
---------------------------------------------------------------------------
    Mr. Beck. Just give me a moment to get to that, Dr. Coburn.
    Dr. Coburn, this is an email that I wrote from an investor 
conference. The Long Beach relative performance was discussed 
repeatedly with investors at the conference, so I would have 
been made aware of their relative performance, as you say, 
talking to people in the market.
    Senator Coburn. OK. Did you continue selling similar Long 
Beach paper even after making that comment?
    Mr. Beck. Yes, we did.
    Senator Coburn. OK. Did you alter your securitization 
practices based on that knowledge?
    Mr. Beck. I cannot recall that we did, Dr. Coburn.
    Senator Coburn. I asked the other panel, and Mr. Vanasek 
and Mr. Cathcart said investors should know about fraud 
problems. I also asked if they were owners, should they. There 
is also an SEC requirement that requires notification of any 
material adverse factor. Were you aware of the nature and depth 
of the problems with the significant number of loans that were 
originated that either did not qualify, had false 
documentation, or had no documentation?
    Mr. Beck. I was not aware of the specific documents that 
you referenced earlier. No, I was not.
    Senator Coburn. So you were seeing the end results of what 
had come through, and you were packaging it and selling it. And 
after you received the information that its performance was 
poor, did you inquire to say why is our paper performing more 
poorly than others?
    Mr. Beck. Yes, we did a couple of things, Dr. Coburn. In 
the course of our securitization before the loans are pooled, 
there are post-closing reviews, many of which you have seen in 
this documentation that are done by Origination, and their 
intent is to identify and remove loans from the pool or that 
will come to me and my team that have underwriting defects.
    After we receive the salable loans, an underwriting due 
diligence process is undertaken where a statistically 
significant sample of the loans is taken, both adverse as well 
as random, to try to identify any further underwriting defects 
and have those loans removed from the pool so that when we come 
to the process of securitization, the loans are all performing, 
they are current, and loans with underwriting defects should 
have been removed.
    Now, as you know, and as we have seen, some loans with 
fraud and with underwriting defects do slip through. That 
happens. And it is not a good thing for us ever. We have an 
operational and reputational problem, and we have a big 
financial problem, as we have talked about, in terms of 
repurchase liability. Each transaction, though, does have a 
warrant on it, and the investors can ask us to repurchase the 
loans.
    Senator Coburn. All right. So your ability to sell into the 
future is dependent on the quality of the product that you are 
selling today?
    Mr. Beck. Yes, it is.
    Senator Coburn. OK. I will yield back.
    Senator Levin. Thank you. Senator Kaufman.
    Senator Kaufman. Mr. Beck, what is a stated income loan?
    Mr. Beck. As Mr. Cathcart said, the borrower does not 
document their income on the application.
    Senator Kaufman. And why was that developed? It seems a 
little unusual, doesn't it?
    Mr. Beck. Stated income loans were developed for customers 
that did not get a W-2, generally, were self-employed.
    Senator Kaufman. Mr. Schneider, why was that developed? Why 
did it go beyond that? It clearly went beyond that, right?
    Mr. Schneider. Yes, it did, Senator. I think what happened 
in the industry is, if you looked at performance of mortgage 
loans, what tended to drive, what was the dominant driver of 
performance was the FICO score and the LTV. And income was not, 
at least in the older vintages--2005 to 2006--a material driver 
of performance. I think as we got into 2006 we saw some of 
those changes, and that is where the industry started to 
tighten standards and require additional documentation.
    Senator Kaufman. Can you think of another place you can go 
and get a loan without disclosing your income?
    Mr. Schneider. The income was disclosed----
    Senator Kaufman. No, excuse me. Where people would just 
take your word. I mean, it just seems such a foreign concept to 
me that you could go into anyone and borrow money and they 
said, ``What is your income? Can you document it?'' and you 
say, ``Well, I am just going to tell you what it is,'' and we 
are off to the races.
    Mr. Schneider. No, Senator.
    Senator Kaufman. OK. What size mortgages were stated income 
loans used for WaMu?
    Mr. Schneider. I do not recall any specific limit on the 
size.
    Senator Kaufman. So basically any mortgages you sold could 
be stated income loans.
    Mr. Schneider. Could have been.
    Senator Kaufman. When a stated income loan was resold, did 
the prospectus disclose that the loan was made without 
verification of borrower income?
    Mr. Beck. The documentation type is disclosed.
    Senator Kaufman. So, in other words, if I picked up a 
prospectus and actually went through the whole thing on the 
mortgage-backed securities, it would say these loans are based 
on stated income?
    Mr. Beck. That would be in the prospectus supplement, and 
in terms of disclosures, Senator, it is important to recognize 
that is not the limit--the prospectus, that is--of the 
information that an investor would have. They have access to 
the loan tape which had each loan and its risk characteristics 
on it. As we have talked about, they had rating agency 
feedback, and they knew all the historical performance of the 
shelf from which we had been selling. So they had a significant 
amount of information beyond the prospectus supplement.
    Senator Kaufman. Do you have reason to believe that 
specific borrowers were lying about their income in these 
products, Mr. Schneider?
    Mr. Schneider. As we looked at the performance of loans and 
saw early payment defaults, we did see instances of where 
borrowers were lying about their income.
    Senator Kaufman. Did everyone in the management at WaMu 
know that, do you think?
    Mr. Schneider. I cannot speak for everybody.
    Senator Kaufman. The top management at WaMu, do you think 
were aware of the fact that there was a problem that some 
stated income was not accurate?
    Mr. Schneider. I would presume so.
    Senator Kaufman. At what point did you kind of get worried 
about this? I mean, stated income, it just seems like so 
difficult to understand. I have a hard time dealing with the 
stated income concept. But then I have a more difficult time as 
things go on and these things are growing and the more 
indications you are getting, the stated income is not working. 
Was there any concern expressed by top management about this?
    Mr. Schneider. Senator, I think we were all very concerned 
about it. We tightened credit standards in our subprime space 
significantly in 2006 when we started to see the challenges, 
and then we tightened credit standards in our prime space, in 
our Option ARM book, and on, frankly, all lending types 
throughout 2007 as we experienced challenges with the 
performance.
    Senator Kaufman. Did you have any reason to believe that 
WaMu's internal controls were insufficient to deter fraud in 
these products?
    Mr. Schneider. Senator, I think over the course of the 2\1/
2\ years I was there, I think we made improvements. I do not 
think we were ever fully satisfied that all of the improvements 
were in place, and we continued to work on it.
    Senator Kaufman. Mr. Beck, did you inform prospective 
investors that you were concerned about the internal fraud in 
the organization?
    Mr. Beck. We informed investors, Senator, of the risk 
characteristics of the loans, and as I said in my previous 
testimony, we had internal processes in place to remove loans 
that had identified fraud before we sold them.
    Having said that, some fraudulent loans do slip through, 
some loans with underwriting defects, and the investor had the 
opportunity to put those loans back to us.
    Senator Kaufman. Mr. Schneider, did you ever--I think you 
said you decided to stop stated income loans.
    Mr. Schneider. Correct.
    Senator Kaufman. And when did you do that?
    Mr. Schneider. It would have been late 2006, early 2007.
    Senator Kaufman. And why did you do that?
    Mr. Schneider. We were not satisfied with the performance.
    Senator Kaufman. So you just eliminated all of them. You 
did not go back and just eliminate some of them. You just said 
from now on, WaMu will not accept stated income loans.
    Mr. Schneider. On a prospective basis, yes.
    Senator Kaufman. And at that point, what percentage did you 
think of those stated income loans were not accurate?
    Mr. Schneider. I am not sure.
    Senator Kaufman. But it had to be a preponderance, right, 
for you to totally eliminate stated income loans as opposed to 
just saying--I mean, if it was 10 percent, you clearly would 
not eliminate all stated income. You would try to put in 
tighter internal controls to identify those 10 percent or 15 
percent or 20 percent. I would assume it would have to be a big 
number to just say we are not going to do this anymore.
    Mr. Schneider. Well, our expectations around delinquency 
were low single-digit numbers, so if delinquencies did get to a 
10-percent number on a particular product, we would probably 
stop it. That was too high for us even at that level.
    Senator Kaufman. OK. And you said you closed Long Beach?
    Mr. Schneider. Yes, sir.
    Senator Kaufman. And why did you do that?
    Mr. Schneider. As we got into 2007, three or four things 
happened. The subprime market was increasingly challenged. We 
saw signs that home prices were starting to deteriorate. Long 
Beach, as I showed you on the numbers earlier, as a percentage 
of our business was relatively small, actually very small as a 
percentage of our business, and it simply was not worth the 
management attention required at that point.
    Senator Kaufman. But you have been getting reports--and I 
know you just came in 2005, right? You are getting reports, I 
mean just terrible things are going on down at Long Beach. I 
mean, based on the previous panel and just what you have said, 
it was such a small portion of the business, and there was so 
much problem with that area, I just wonder why you waited until 
2007 to close it down?
    Mr. Schneider. It was a course of around--my initial charge 
was to go in there and see if I can fix it. We tried as hard as 
we could and ultimately decided to shut it down.
    Senator Kaufman. OK. How would you characterize WaMu's 
relationship with its regulators, OTS especially?
    Mr. Schneider. We had a positive working relationship with 
the OTS, met with them on a quarterly basis. I probably met 
with the individual regulators monthly.
    Senator Kaufman. And Mr. Vanasek and Mr. Cathcart both 
testified that while the line regulators were diligent, the 
leadership did not support their conclusions. Did you find 
that, or was that something you just did not deal with?
    Mr. Schneider. Senator, that would not be something I would 
be involved in.
    Senator Kaufman. How did WaMu use FICO scores?
    Mr. Schneider. Senator, FICO scores would be one attribute 
of the loan decision, so we would have FICO score criteria as 
well as LTV, documentation, etc.
    Senator Kaufman. And are they a good indicator, in your 
opinion, of creditworthiness?
    Mr. Schneider. Yes, they are.
    Senator Kaufman. And they are a pretty accurate indicator 
of salability into the after-market, do you think?
    Mr. Schneider. I think it is the best measurement that is 
available that gives investors an opportunity to understand one 
loan versus the other, the characteristics of that borrower's 
creditworthiness.
    Senator Kaufman. Mr. Beck, is that your opinion, too?
    Mr. Beck. My opinion on FICO is that it is one of many 
risks that are evaluated. LTV is important. Documentation type 
we have talked a lot about; owner occupied/non-owner occupied; 
geography; we talked about California risk. So there are a 
variety of risks that are important in evaluating the expected 
losses on a loan.
    Senator Kaufman. We talked earlier about Mr. Lewis' book 
``The Big Short.'' In that he said that there were loans with 
borrowers who had scores in the 550 range, FICO scores. Did 
WaMu have mortgages that they securitized in the 550 range, 
would you say?
    Mr. Beck. I cannot recall for sure, but we may have had 
FICOs under 600. And under 600 would be low.
    Senator Kaufman. And so would you agree with Michael Lewis 
in his book that those kind of loans were virtually certain to 
default, 550?
    Mr. Beck. I would agree with Michael Lewis that they had 
much higher expected credit losses than a borrower that has a 
750 FICO.
    Senator Kaufman. Both Mr. Cathcart and Mr. Vanasek said 
that in order for 550 to even survive, you would have to have 
kind of hands-on management day to day with the borrower. Did 
that go on, to either one of your knowledge, at WaMu?
    Mr. Schneider. Yes, Senator. For our subprime servicing, we 
put them in a higher-risk servicing protocol, which meant we 
called them earlier and more often and worked more closely with 
those borrowers.
    Senator Kaufman. What is the concept of a skinny file? Are 
you familiar with the term ``skinny file'' with regard to FICO?
    Mr. Schneider. I am not, Senator.
    Senator Kaufman. OK. That is the policy that said that a 
skinny file is a good file. In fact, there is a quote from the 
Seattle Times article, WaMu employee recalled the big saying 
was that a skinny file was a good file. What is a skinny file 
and why is a skinny file a good file? But you did not have any 
indication of that, Mr. Schneider. Mr. Beck, a skinny file, you 
have no knowledge of that?
    Did you feel any pressure from Wall Street in terms of 
generating more mortgage-backed securities in addition to the 
fact it was profitable, clearly, but did you get a feeling that 
this was something that was very competitive and something you 
should be into?
    Mr. Schneider. Senator, that was not a driver of our 
activities. I mean, if you look at the results of the mortgage 
business at Washington Mutual for the time I was there, we did 
nothing but lower volume and systematically shut down the 
business.
    Senator Kaufman. How would you characterize, just off the 
top of your head--I mean, it sounds to me that we heard a whole 
bunch of horror stories this morning, and this book is full of 
horror stories. I admit a lot of them happened before you came. 
When you showed up at WaMu and you took a look at what was 
going on--you were assigned to look after Long Beach and the 
rest of that. What went through your mind? Was it like, Wow, 
this is really a challenge, or this is a serious challenge? I 
mean, what were you thinking? How unusual did you find the 
situation there. It sounds very unusual to me.
    Mr. Schneider. Senator, it was a very big challenge. I 
spent a lot of time trying to make Long Beach as successful as 
possible. I tried management changes. We changed products. So 
it was a significant challenge.
    Senator Kaufman. Great. Thank you very much.
    Senator Levin. Thanks, Senator Kaufman.
    First on the numbers of originations and securitizations, 
you testified that the Option ARM lending decreased by more 
than 50 percent from 2005 to 2006. What you, of course, leave 
out is that your Option ARM lending in 2006 was still 
significantly higher than it was in 2003. And you also do not 
mention that the major reduction that you will see in 
originations occurred on your fixed traditional loans. That is 
what caused the major drop from 2003. From that point on, there 
was a slightly different story with different mortgages, but 
the major drop which you and others from WaMu refer to came in 
the fixed, 30-year loans, and that drop took place when you 
decided to engage in a higher-risk strategy. So you got less 
origination and purchases of your traditional loans, your 
lower-risk loans, and you instead engaged, starting in 2004, in 
this higher-risk strategy, and we saw what the outcome of it 
was.
    But in terms of Option ARMs--and we will put this in the 
record--according to your SEC filings, Option ARMs were $30.1 
billion in 2003, went up to $67 billion in 2004, went up to $63 
billion from the 2003 level in 2005, and still was above the 
2003 level in 2006. Fixed loans went from $263 billion in 2003, 
dramatically down in 2004 to $77 billion, then $78 billion, 
then $47 billion. So the real explanation here for this shift 
that you make big reference to has to do with the dropping of 
the fixed loans, securitizations and originations. The increase 
in the Option ARMs was pretty steady through 2006. Although it 
dropped, as you point out, from 2005 to 2006, still it was 
above the 2003 level.
    I want to talk to you about Exhibit 50, Mr. Beck.\1\ This 
is a November 2006 memo that has been made reference to about 
Long Beach paper being among the worst performing paper in the 
market. This was in November 2006. And then the Comptroller of 
the Currency, the OCC, did an analysis on the highest rates of 
foreclosure in 2008, and this is in Exhibit 58,\2\ and it 
showed Long Beach being in the top ten in nine out of ten metro 
areas.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 50, which appears in the Appendix on page 670.
    \2\ See Exhibit No. 58, which appears in the Appendix on page 698.
---------------------------------------------------------------------------
    Were you aware of these findings of the OCC?
    Mr. Beck. No, I was not.
    Senator Levin. Should you have been made aware of them?
    Mr. Beck. Mr. Chairman, I am not familiar at all with this 
document. This is from the OCC?
    Senator Levin. Yes. I am asking, should you have been aware 
of the OCC findings, given your position, should----
    Mr. Beck. I was not aware of this particular report----
    Senator Levin. No, I am not talking about the report. I am 
saying should you have been familiar with their findings. That 
is all.
    Mr. Beck. I cannot say.
    Senator Levin. Take a look at Exhibit 22a now,\3\ if you 
would. This is a November 2005 internal WaMu memo called ``So. 
CA [Southern California] Emerging Markets Targeted Loan Review 
Results.'' It describes a year-long internal investigation into 
suspected fraud affecting loans issued from your two processing 
centers, Montebello and Downey. You heard in the prior panel 
that it laid out an extensive level of loan fraud. Forty-two 
percent of the loans reviewed contained suspect activity or 
fraud, virtually all of it attributable to some sort of 
employee malfeasance. And then in Exhibits 22b and 23b,\1\ 
there is additional detail about the investigation, including 
the percentage of loans containing fraudulent information at 
the Montebello office at 83 percent, the percentage in the 
Downey office 58 percent.
---------------------------------------------------------------------------
    \3\ See Exhibit No. 22a, which appears in the Appendix on page 509.
    \1\ See Exhibits No. 22b and 23b, which appear in the Appendix on 
pages 497 and 511.
---------------------------------------------------------------------------
    Now, were you aware at the time of those findings?
    Mr. Beck. No, I was not. I am not copied on this.
    Senator Levin. Should you have been?
    Mr. Beck. I was aware that there was fraud, as I said 
earlier, and I was aware that certain loans had underwriting 
defects. And as part of the post-closing review that 
Origination was conducting, I understood that loans with 
identified fraud or underwriting defects would have been 
removed from the pool of loans that I was going to be 
securitizing.
    Senator Levin. You thought they were going to be removed?
    Mr. Beck. Yes, that is what I believed.
    Senator Levin. And did you check to see if that was true?
    Mr. Beck. What we did subsequent to that, Mr. Chairman, is 
to do a due diligence review separate and distinct by the 
underwriter, WCC, or----
    Senator Levin. Did you check to see whether they were 
removed before you put those securities on the market?
    Mr. Beck. No, I did not.
    Senator Levin. Purchasers of these securities are relying 
on you as an underwriter to provide truthful information. You 
had evidence of the fraud. You knew of it. You had heard of it. 
And yet you did not check to see whether or not that the fraud-
tainted mortgages were removed from the security. Wasn't that 
your job or part of your job?
    Mr. Beck. I understood that there was fraud.
    Senator Levin. Shouldn't you have checked to make sure that 
the fraudulent, tainted mortgages were not part of those 
securities before you peddled them? Isn't that part of your 
job?
    Mr. Beck. No, it is not. The important aspect of this--and 
I take your point--it is important to not sell loans that are 
defective. However, the post-closing review is conducted by the 
origination channel, conducted by Credit in the origination 
channel.
    Senator Levin. Who is that specifically?
    Mr. Beck. The post-closing review would be conducted by the 
Operations Department within the origination channel with the 
help of Credit.
    Senator Levin. Give me the names of the people in charge.
    Mr. Beck. Well, I would point you to the prior panel, 
ultimately.
    Senator Levin. All right. So it was their job to check to 
make sure that the mortgages that they and you knew were 
tainted were not part of securities.
    Mr. Beck. Yes, that the process in place was removing loans 
that were defective.
    Senator Levin. And it was not your job, it was their job, 
the previous panel's job?
    Mr. Beck. I had a separate responsibility to conduct 
underwriters' due diligence, which we did.
    Senator Levin. All right. And you never asked to see if 
they were removed?
    Mr. Beck. I did not.
    Senator Levin. Mr. Schneider, take a look at Exhibit 24,\1\ 
if you would. Fraud problems resurfacing with a gusto in early 
2008. This is an April 4 memo from the WaMu Corporate Fraud 
Investigation and Audit Section. It says that one of the 
mortgage insurers refused to insure any more loans issued by 
the loan officer from the Montebello loan office. That was the 
same loan officer who was investigated in 2005. It describes 
the earlier 2005 investigation, and states that virtually no 
actions were taken in response to it. It says that another 
review of loans issued by the Montebello office in 2007--and 
this is what is now reported in this April 2008 audit--found 
that 62 percent contained fraudulent information.
---------------------------------------------------------------------------
    \1\ See Exhibit No. 24, which appears in the Appendix on page 515.
---------------------------------------------------------------------------
    Were you aware of this audit?
    Mr. Schneider. Yes, I was, Mr. Chairman.
    Senator Levin. All right. What did you do?
    Mr. Schneider. This audit was actually conducted by the 
Legal and HR group. I was aware of it, but they were conducting 
it. Whenever I found out about cases of fraud, I asked that an 
investigation happen. We had no interest in fraud, no interest 
in our originators perpetrating the fraud.
    Senator Levin. Yet it continued to happen year after year 
after year, and you are selling the securities that those 
fraudulent mortgages are included in. Now, what action did you 
insist upon? You are out there selling these securities.
    Mr. Schneider. In the cases where we found fraud in loans, 
we would buy those loans back.
    Senator Levin. It is not where you found it. It is where 
people complained about it. But when you saw that audit, in 
April, you saw the continuation of fraud year after year, it 
said the 2005 fraud continued, it said in 2007 the fraud 
continued. You are out there selling securities. Do you not 
have a responsibility to take steps to make sure that fraud 
ends so you are not just looking back after someone finds out 
after the security is sold, but that you take actions to 
prevent those securities from being sold? Isn't that your 
responsibility?
    Mr. Schneider. It is my responsibility to handle fraud.
    Senator Levin. And what actions did you take when this 
April 4, 2008, memo came to your attention?
    Mr. Schneider. We terminated the people who admitted to 
committing that fraud.
    Senator Levin. Did you offer them jobs?
    Mr. Schneider. No, I did not.
    Senator Levin. Did the company offer them jobs?
    Mr. Schneider. To the people we terminated?
    Senator Levin. Yes.
    Mr. Schneider. We did not.
    Senator Levin. OK. And did you go after the securities that 
included the fraudulent mortgages to notify the people that 
there may be fraud in those securities? Did you take that 
initiative?
    Mr. Schneider. That initiative was taken by the Legal 
Department, which was best able to address the situation.
    Senator Levin. Do you know that they took the initiative to 
notify people, or are you saying it would have been taken by 
them?
    Mr. Schneider. It was my understanding they were going to 
look at it and make the determination.
    Senator Levin. As to whether or as to----
    Mr. Schneider. Whatever determination was appropriate.
    Senator Levin. Did you find out whether they did it?
    Mr. Schneider. I did not.
    Senator Levin. You are out there selling these securities. 
You know there is fraud in some of these securities. You say it 
is your job to make sure that does not happen. You say, well, 
the Legal Department was presumably going to take action, and 
you never follow up to ask the Legal Department whether they 
took action. I don't get it.
    Mr. Schneider. I expected that they would do what they----
    Senator Levin. But you did not ask to see if they did it.
    Mr. Schneider. I did not, Mr. Chairman.
    Senator Levin. Take a look, if you would, Mr. Schneider, on 
page 7 of this Exhibit 24. It says there that WaMu has no 
record of action taken for performance issues with certain loan 
officers. Right in the middle it says Walker and Kusulas, and 
they are two WaMu agents. WaMu had ``no record of action taken 
for performance issues'' with those two offices that are named 
there. What that is referring to is what is summarized on the 
previous page, the prior referrals to the Corporate Fraud 
Investigations Office led to eight separate investigations from 
2004 to 2007, two cases each year, with the loan officers from 
the Montebello office listed as persons related to the case. 
Now, that is what is on page 6. You will see the term ``prior 
referrals,'' about the fourth paragraph. Do you see that?
    Mr. Schneider. Yes, I do.
    Senator Levin. It led to eight separate investigations in 
that 4-year period, two cases each year with those two people. 
No one interviewed one of the people involved until January 
2008, by the way.
    And then it says that WaMu--and I am now going back to page 
7--WaMu had no record of action taken for performance issues 
with those loan officers. Now, I do not know how a bank can 
possibly operate with credibility with this kind of problem, 
this kind of fraud in its midst. But instead of getting 
disciplined or fired for fraudulent loans coming out of the 
offices, those top loan officers from Montebello and Downey 
during the same period that they were being investigated--that 
is 2004 to 2007--were rewarded each year with an invitation to 
the President's Club, which is WaMu's highest honor, including 
all-expenses-paid trips to places like Hawaii and the Bahamas. 
You were, I think, very much involved in the President's Club, 
which made sure those all-expense-paid trips were made.
    How does that happen? You have loan officers under 
investigation year after year after year. Instead of being 
disciplined or fired, they are given rewarding trips to Hawaii 
and the Bahamas. How does that happen?
    Mr. Schneider. Mr. Chairman, in cases of fraud where there 
is an investigation, I ask the HR group and the Legal group to 
do the fraud investigations. If they came back with a 
recommendation to terminate or punish an employee, then I would 
have taken that recommendation.
    Senator Levin. Were you aware of the fact those 
investigations were going on in every one of those years?
    Mr. Schneider. I was not.
    Senator Levin. Should you have been?
    Mr. Schneider. It depended on how big people thought it 
was.
    Senator Levin. Wasn't there a recommendation in 2005 to 
take action against those officers?
    Mr. Schneider. That 2005 report, which I see here, was 
something I was not familiar with. I do not know what the 
specific recommendations were. That was right at the beginning 
of the time I joined the company.
    Senator Levin. Back in 2005, this is what was recommended. 
Exhibit 22a at the bottom.\1\ This memorandum outlines a few of 
the most egregious activities identified based on targeted 
reviews with particular documentation of specific areas of 
failure to follow policy. ``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.''
---------------------------------------------------------------------------
    \1\ See Exhibit No. 22a, which appears in the Appendix on page 496.
---------------------------------------------------------------------------
    Well, that firm action was paid trips to Hawaii and the 
Bahamas. That is what the action was. Are you troubled by that? 
Do you think the bank should be troubled by that?
    Mr. Schneider. I think anytime----
    Senator Levin. Do you think your investors should be 
troubled by that? Should your stockholders, should anybody be 
troubled by that except us?
    Mr. Schneider. Mr. Chairman, anytime there is fraud, we 
took it very seriously.
    Senator Levin. No, when there was fraud, what you do is 
reward the folks that are being investigated with trips. That 
is the action, year after year, to the President's Club. And 
then you say in this Exhibit 62,\2\ by the way, you hope to see 
all these folks--not specifically these folks, but you hope to 
find the employees, the top sales people of WaMu, hope to see 
them all in Hawaii, David Schneider.
---------------------------------------------------------------------------
    \2\ See Exhibit No. 62, which appears in the Appendix on page 727.
---------------------------------------------------------------------------
    Take a look, if you would, Mr. Schneider, at Exhibit 30.\3\ 
It is an internal WaMu document called a ``Significant Incident 
Notification'' dated April 1, 2008. Now, this is Westlake 
Village, so that is near Los Angeles. These were loans that 
were issued in 2007, but the report is dated April 1, 2008.
---------------------------------------------------------------------------
    \3\ See Exhibit No. 30, which appears in the Appendix on page 544.
---------------------------------------------------------------------------
    First bullet point: ``Many of the loans had several fraud 
findings such as fabricated asset statements, altered 
statements, income misrepresentation and one altered statement 
that is believed to have been used in two separate loans.''
    The third bullet point: ``One Sales Associate admitted that 
during that crunch time some of the Associates''--now, we are 
talking here about Westlake Village--``would `manufacture 
asset' statements from previous loan documents and submit them 
to the LFC.'' And this associate ``said the pressure was 
tremendous from the LFC to get them the documents since the 
loan had already funded and pressure from the Loan Consultants 
to get the loans funded.''
    Take a look at Exhibit 31.\1\ This is a memo summarizing 
the same April 2008 investigation. Page 2 of Exhibit 31. 
``Sales Associates would take [asset] statements from other 
files and cut and paste the current borrower's name and 
address.''
---------------------------------------------------------------------------
    \1\ See Exhibit No. 31, which appears in the Appendix on page 546.
---------------------------------------------------------------------------
    Now, were you informed, Mr. Schneider, about the 
investigation of the Westlake Village office?
    Mr. Schneider. I was, Mr. Chairman.
    Senator Levin. I am not sure. You said, I was or I wasn't?
    Mr. Schneider. I was.
    Senator Levin. Were you aware that WaMu employees were 
cutting corners, engaging in fraud to churn out a high volume 
of loans?
    Mr. Schneider. Mr. Chairman, when that happened, we took it 
very seriously. In no way did I think that fraud shouldn't be 
treated with the utmost seriousness, and I think ultimately 
some of our sales associates were terminated for their behavior 
that violated our code of conduct.
    Senator Levin. The two guys that were terminated told us 
they were offered jobs. But my question is, what did you do at 
the time? Did you get back into those securities and make sure 
that the people who bought them were notified?
    Mr. Schneider. I don't know specifically what was done, Mr. 
Chairman.
    Senator Levin. Did you find out at the time? Did you ask?
    Mr. Schneider. I don't recall asking.
    Senator Levin. Take a look at Exhibit 28.\2\ These are 
minutes dated December 12, 2006, from the Market Risk 
Committee, WaMu. Page 4.
---------------------------------------------------------------------------
    \2\ See Exhibit No. 28, which appears in the Appendix on page 537.
---------------------------------------------------------------------------
    Near the bottom, ``delinquency behavior was flagged in 
October [2006] for further review and analysis when recent 
securitization deals appeared to have more severe delinquency 
behavior than experienced in past deals. The primary factors 
contributing to increased delinquency appear to be caused by 
process issues including the sale and securitization of 
delinquent loans''--sale and securitization of delinquent 
loans--``loans not underwritten to standards, lower credit 
quality loans and seller services reporting false delinquent 
payment status.'' What did you do about it?
    Mr. Schneider. Mr. Chairman, I was not a member of the 
Market Risk Committee, so I have not seen this document before 
today.
    Senator Levin. You never saw the document at that time? 
Does it trouble you now that this was the first time you have 
seen this document?
    Mr. Schneider. I think I saw it yesterday in preparation.
    Senator Levin. Yesterday, you saw it for the first time?
    Mr. Schneider. Yes, sir.
    Senator Levin. What was your reaction?
    Mr. Schneider. That it should not happen.
    Senator Levin. Should not happen. These are securities that 
happened on your watch.
    Mr. Beck, they are on your watch, too. Were you aware of 
these documents?
    Mr. Beck. I am.
    Senator Levin. Were you then?
    Mr. Beck. I was aware of this at the time. I do recall 
this, and we bought the securities--we bought the loans back--
--
    Senator Levin. That were brought to your attention? So you 
went out and looked for them?
    Mr. Beck. Yes, we did.
    Senator Levin. Did what?
    Mr. Beck. We bought the loans back that we sold----
    Senator Levin. Did you go out and look for them after you 
found out about it? When you read these documents----
    Mr. Beck. Yes.
    Senator Levin [continuing]. That fraudulent mortgages had 
been securitized----
    Mr. Beck. This document says that we sold loans that were 
delinquent and that is never right. That is never what we 
represent, and----
    Senator Levin. And what did you do? At the time you saw 
this, right?
    Mr. Beck. Right. We bought the loans back.
    Senator Levin. Yes, I know. Did you go out and look for 
them? Did you initiate the recovery of----
    Mr. Beck. Yes. Tom Lehmann worked for me, the person that 
is making this report, and----
    Senator Levin. You told him at the time, go and find every 
single one of these loans, and on all these other documents, as 
well, now, where you found all these fraudulent loans----
    Mr. Beck. I am talking about this specific question right--
--
    Senator Levin. How about the previous question?
    Mr. Beck [continuing]. Because I remember this----
    Senator Levin. How about the previous documents?
    Mr. Beck. When we--so when we identified----
    Senator Levin. When you saw these documents--we have talked 
three or four documents here.
    Mr. Beck. Yes.
    Senator Levin. When you saw these documents, you are 
saying, in every case, you told your people, go and find every 
single security that incorporated these fraudulent loans. We 
are going to buy them back. Is that what you----
    Mr. Beck. That is not what I said. No. I said I remember 
and recall this specific event because we did go out--because 
we securitized loans that were delinquent, which we represent 
that we won't do and we shouldn't do, and these were loans 
purchased from third parties and the loan servicing tape that 
we got from them was incorrect. It was wrong. And when we found 
that out, we went and purchased these loans back.
    Senator Levin. You notified everybody?
    Mr. Beck. Yes, I believe we did. I believe we made a filing 
on this particular issue.
    Senator Levin. Now, what about the earlier ones where the 
fraud was identified in those offices? Did you go back and 
identify what securities incorporated those mortgages that were 
fraudulent from those offices?
    Mr. Beck. I am not certain, Mr. Chairman, that the loans 
from that analysis ever got into a securitization in the first 
place.
    Senator Levin. Did you check out when you saw the audits?
    Mr. Beck. I never saw the audits.
    Senator Levin. You never saw the two audits that we have 
talked about here today?
    Mr. Beck. No.
    Senator Levin. Should you have seen them?
    Mr. Beck. I don't know the answer to that. I didn't see the 
audits. What I relied on was that Origination's post-closing 
review would remove defective loans before they were put in the 
warehouse to sell----
    Senator Levin. And did you ever check that out and see if 
it was done?
    Mr. Beck. No, I did not.
    Senator Levin. Senator Kaufman, I have more, but I want to 
just----
    Senator Kaufman. I just have one question. I see this 
November 17, 2005, report found 42 percent of the loans 
contained suspect activity or fraud. Did you go and buy those 
back, do you know?
    Mr. Beck. I don't know that those loans were sold.
    Senator Kaufman. OK. Thank you.
    Senator Levin. Did you check?
    Mr. Beck. I did not. I wasn't copied on the report.
    [Pause.]
    Senator Levin. Now, in general, Mr. Beck, were you aware of 
the 2005 and the 2008 investigations that we have been 
discussing? Is your answer, no, you were not aware of them at 
the time?
    Mr. Beck. I was not.
    Senator Levin. Did you supervise the program that was set 
up to investigate any complaint about your securities and your 
loans? Was there a seven-step program that Long Beach had set 
up? Do you remember that?
    Mr. Beck. Yes, I do.
    Senator Levin. And that was to affirmatively investigate a 
complaint about the loans, is that correct?
    Mr. Beck. Yes. That was set up at the end of 2006, 
beginning of 2007----
    Senator Levin. You supervised that program, right?
    Mr. Beck. Yes.
    Senator Levin. And did you set up a similar program for 
WaMu's loans?
    Mr. Beck. That program was designed for Long Beach. We 
didn't----
    Senator Levin. My question is, did you set up a similar 
program for WaMu's loans?
    Mr. Beck. The Repurchase and Recovery Team also looked at 
requests for repurchase for WaMu loans, but the seven-step 
process that you are referring to was used with Long Beach----
    Senator Levin. Does that mean----
    Mr. Beck [continuing]. As best I can recall.
    Senator Levin. You had all this evidence that there was 
fraud in various offices of WaMu. Why was that not set up for 
WaMu's loans?
    Mr. Beck. We had a significantly higher level of repurchase 
requests from Long Beach and----
    Senator Levin. Take a look, if you would, at Exhibit 34.\1\ 
Now, Exhibit 34 is a report from WaMu's corporate credit review 
group and it found that WaMu's loans marked as containing 
fraudulent information was nonetheless sold to investors. If 
you will take a look at page 3, in the first bullet point----
---------------------------------------------------------------------------
    \1\ See Exhibit 34, which appears in the Appendix on page 564.
---------------------------------------------------------------------------
    Here is what it says. ``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.'' So the controls are not 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. The coding 
of the user to defined risk mitigation field in Fidelity does 
not directly affect the salability of the loans.''
    ``A review was completed of a sample of the 25 loans . . 
.''--this is a sample of 25 loans closed in 2008--``with the 
appropriate coding in the Risk Mitigation field. . . . 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.''
    Do you recall this report and that finding, Mr. Beck?
    Mr. Beck. I do not.
    Senator Levin. Should you have seen this report?
    Mr. Beck. Yes.
    Senator Levin. Were you aware that for some time, WaMu had 
been selling loans to investors even after the loans had been 
marked as containing fraudulent information?
    Mr. Beck. No.
    Senator Levin. Well, now you were head of the Capital 
Markets Group, right, at that time?
    Mr. Beck. That is correct.
    Senator Levin. Is there any way that you should not have 
been informed about this?
    Mr. Beck. I would expect that I would be informed of this, 
yes.
    Senator Levin. I mean, this is damning stuff. You are 
working for a bank which according to a 25-loans test had 
almost half reflecting a sale after an investigation has 
confirmed fraud, and this review says that failure has existed 
for some time, that control weakness has existed for some time.
    Now take a look at Exhibit 40b,\1\ if you would. Senator 
Kaufman, any time you want to jump in here, please do.
---------------------------------------------------------------------------
    \1\ See Exhibit 40b, which appears in the Appendix on page 632.
---------------------------------------------------------------------------
    Exhibit 40b. Now, this one is going to take some difficult 
following because it is an email chain, so we have to start at 
the first email, which is on page 4--it is at the end--and work 
back up to page 1. But take a look on page 4. You will see 
there on February 14, 2007, Michael Liu writes to Mr. Elson. 
Mr. Elson is the Senior Vice President for Portfolio 
Management, and here is the subject, ``Option ARM MTA''--which 
is the Monthly Treasury Average--``Option ARM MTA and Option 
ARM MTA Delinquency.'' Notice that, delinquency. So now we have 
an Option ARM MTA, which is an Option ARM that has an interest 
rate adjusting to the monthly Treasury average, is that right?
    Mr. Beck. That is right.
    Senator Levin. And the email points out some information--
FICO scores, loan-to-value ratios about the delinquent non-
conforming Option ARMs. Do you see where it says that? It says 
some information there about FICO scores and about----
    Mr. Beck. Some points for Option ARM----
    Senator Levin [continuing]. Loan-to-value ratios. Do you 
see that there?
    Mr. Beck. I do.
    Senator Levin. OK. Now, a few minutes later, still on 
February 14, working ourselves now to page 3, you will see that 
Elson forwards this email to somebody whose name, I believe, is 
Youyi Chen. Do you know who that person is?
    Mr. Beck. I do.
    Senator Levin. Is that a man or a woman?
    Mr. Beck. It is a man.
    Senator Levin. A man. So Mr. Chen is being sent this email, 
subject, Option ARM Delinquency. It says, ``Youyi--attached is 
a description of the Option ARMs that were delinquent in the 
2006 [fourth quarter]. You can see that it is very much a 
function of FICOs and Low Document loans. We are in the process 
of updating the . . . matrix. . . . Your comments are 
appreciated.''
    So now go up that page and you will see shortly thereafter, 
a couple hours thereafter, there is a letter or an email sent 
from--and you said Mr. Chen, is that correct? Did you say it 
was a male or a female? I am sorry.
    Mr. Beck. It is a male.
    Senator Levin. A male. From Mr. Chen to you, February 14, 
subject, Option ARM Delinquency. ``This answers partially Mr. 
Schneider's questions.. . .'' Apparently Mr. Schneider had 
asked some questions on the breakdown of the Option ARM 
delinquencies. ``The details . . . show Low fico, low document, 
and newer vintages are where most of the delinquency comes 
from, not a surprise.''
    Now, the next email if you keep going up is from you, the 
same day. You are forwarding that email on Option ARM 
delinquencies to Mr. Schneider and to Cheryl Feltgen, who is 
the Head Risk Manager in the Home Loans Division, and here is 
what you wrote. What you wrote is at the top of the page. 
``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 arm is not performing well. 
We should address selling first quarter''--that is 2007, that 
is the quarter you are in--``as soon as we can before we loose 
the opp[ortuni]ty.''
    So in response to the delinquency assessment on Option ARMs 
in your portfolio, you want to sell the newly originated Option 
ARMs, ``newly minted,'' in your words, as soon as you can, 
right? Are you with me so far?
    Mr. Beck. Yes, I am.
    Senator Levin. That is what you want to do.
    Now, later that day--so we are still working up this chain 
of emails--later that day, same subject, Option ARM 
Delinquencies. This is from you to David Schneider. It is now 
Sunday, February 18, 2007. You are still--I am sorry, this is 
from Schneider. I made a mistake. This is from David Schneider 
to you and it says, ``Cheryl, your thoughts?'' A copy goes to 
you and to Cheryl Feltgen. Now Mr. Schneider is saying, 
``Cheryl, your thoughts?'' Do you remember this, Mr. Beck?
    Mr. Beck. Yes, I do recall this.
    Senator Levin. Mr. Schneider, do you remember this?
    Mr. Schneider. I do.
    Senator Levin. OK. Now, later that day--we are still on 
Exhibit 40b \1\--Ms. Feltgen replies, subject still Option ARM 
Delinquency, ``The results described below''--and I am reading 
now from her email--``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 [single-family residential] portfolio.. . . There is a 
meltdown in the subprime market which is creating a flight to 
quality.''
---------------------------------------------------------------------------
    \1\ See Exhibit 40b, which appears in the Appendix on page 632.
---------------------------------------------------------------------------
    ``I was talking to Robert Williams just after his 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,'' which is the 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?''
    That is refreshing, someone who is making clear what is 
really going on. Ms. Feltgen describes, a ``meltdown'' in the 
subprime market, a ``flight to quality.'' Who is going to buy 
Option ARMs which are going to be delinquent? Well, she has 
talked to WaMu executives who have just been to Asia, talked to 
investors who are interested in bonds backed by WaMu mortgages 
and she writes, ``there is still strong interest around the 
world in USA residential mortgages.'' In other words, we can 
still sell our Option ARMs some places. And so she writes, 
``This seems to me to be a great time to sell as many Option 
ARMs as we possibly can.''
    Mr. Beck, you had said pretty much the same thing, sell the 
Option ARMs, ``as soon as we can before we lose the 
opportunity.'' The idea is to sell as many of these 
delinquency-prone loans as possible to investors before their 
performance gets worse and WaMu gets stuck with them.
    The only way that can happen is because you guys at WaMu 
knew something that potential investors didn't, and that is 
that these loans were likely to go delinquent. Now, here is 
what happened.
    Mr. Schneider, you reply late that Sunday evening. The 
subject again, Option ARM Delinquencies. And here is what you 
suggest in this email. You say, ``DB''--and that is Mr. Beck, I 
assume--``and CF''--Ms. Feltgen--you ask Mr. Beck to ``select 
the potential sample portfolios'' and ``coordinate with finance 
on buy/sell analysis,'' and then you ask Ms. Feltgen to run 
credit scenarios.
    Now we are going to the first page of this Exhibit 40b. Now 
it is Tuesday, February 20. Everything is in motion. Mr. Beck, 
you send an email early in the morning, 7:17 a.m. Subject, Re 
Option ARM Delinquency to Ms. Feltgen and to Mr. Schneider, 
making a plan to supply loan-level detail and coordinate with 
finance.
    Now, in the final email of the chain, which is at the top 
of page 1 there, the subject line now reads, ``Urgent need to 
get some work done in next couple days.'' That is added above 
Option ARM Delinquency. Ms. Feltgen directs her staff to start 
analyzing the Option ARM loans in the portfolio. She wrote, 
``We are contemplating selling a larger portion of our Option 
ARMs than we have in the recent past. . . . 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.'' And she asks for ``input on portions,'' her 
words, ``of the Option ARM portfolio that we should be 
considering selling.''
    Now turn to Exhibit 41,\1\ if you would. So far, both of 
you remember everything I have read, do you?
---------------------------------------------------------------------------
    \1\ See Exhibit 41, which appears in the Appendix on page 636.
---------------------------------------------------------------------------
    Mr. Schneider. I do.
    Senator Levin. Mr. Beck.
    Mr. Beck. Yes.
    Senator Levin. OK. Now, turn to Exhibit 41. This is another 
email chain, the same day, February 20. Mr. Shaw sends to Ms. 
Feltgen an analysis of the key characteristics of loans in the 
WaMu portfolio that contributed to rising delinquency rates. 
Shaw to Feltgen and a few others, subject, Urgent need to get 
some work done in next couple of days on Option ARM 
Delinquencies. ``Cheryl, I reviewed the HFI''--the hold for 
investment--``prime loan characteristics that contributed to 
the rising 60+ delinquency rates between January 2006 and 
January 2007. The results of this analysis show that seven 
combined factors contain $8.3 billion of [hold for investment] 
Option ARM balances which experienced above-average increases 
in the 60+ delinquency rate during the last 12 months.'' This 
is an ``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 [hold for sale] pool,''--
shift them, in other words, from holding on to them to selling 
them. Then he lists the factors that went into this change. He 
lists eight specific factors, one being Option ARM loans; two, 
recent vintages, 2004 to 2007; three, in California; four, in 
New York, New Jersey, Connecticut; jumbo loans; and specific 
FICO scores. And then he wrote, ``I recommend we select loans 
with some or all of these characteristics to develop a [hold 
for sale] pool.''
    So he presented a recipe for selecting Option ARM loans--
those most likely to go delinquent--so they could be put up for 
sale before they actually went delinquent and got stuck on 
WaMu's books or discounted. Is that right? Is that a fair 
reading of that, Mr. Beck?
    Mr. Beck. Mr. Shaw is laying out the risks as he sees them 
in the pool----
    Senator Levin. He is laying out----
    Mr. Beck [continuing]. And the risk factors that are going 
to contribute to delinquencies.
    Senator Levin. Yes.
    Mr. Beck. Yes.
    Senator Levin. OK. Now, that day, Ms. Feltgen emails the 
recipe on to you, Mr. Beck. This is the top of that Exhibit 
41.\1\ The subject is, ``Some thoughts on targeted population 
for potential Option ARM MTA loan sale.'' She writes, ``it 
might be helpful insight to see . . . the components of the 
portfolio that have been the largest contributors to 
delinquency in recent times.'' The whole focus here is 
delinquency, delinquency, delinquency.
---------------------------------------------------------------------------
    \1\ See Exhibit 41, which appears in the Appendix on page 636.
---------------------------------------------------------------------------
    Now take a look at 42b.\2\ This chain of emails starts 5 
days later, on February 25, 2007. The first email is from you, 
Mr. Beck, to yourself and to Mr. Schneider and Mr. Rotella, and 
here is what you wrote. ``David 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 the first 
quarter 2007. That amounts to roughly 3B [$3 billion] of Option 
ARMs available for sale. I would like to get these loans into 
[hold for sale] immediately so that I can sell as many as 
possible in the first quarter.'' Sounds urgent. Mr. Beck, is 
the David you are referring to there, Mr. Schneider?
---------------------------------------------------------------------------
    \2\ See Exhibit 42b, which appears in the Appendix on page 638.
---------------------------------------------------------------------------
    Mr. Beck. Yes.
    Senator Levin. OK. Mr. Schneider, do you recall giving that 
instruction to Mr. Beck?
    Mr. Schneider. Mr. Chairman, I recall a decision being made 
in ALCO to sell more Option ARMs and provide more liquidity and 
capital for the company.
    Senator Levin. Yes. Do you remember giving that direction?
    Mr. Schneider. Yes, I do.
    Senator Levin. OK. Now, about 2 weeks after this email, the 
Market Risk Committee gives approval to move up to $3 billion 
in Option ARMs out of the investment portfolio and into the 
sale portfolio, is that correct?
    Mr. Schneider. That is correct.
    Senator Levin. And Exhibit 43 is the March 9, 2007, minutes 
of the Market Risk Committee reflecting the unanimous approval 
to transfer.\3\ Now, how many of the $3 billion in Option ARMs 
that were authorized for sale by the Market Risk Committee 
were, in fact, sold? Do you know?
---------------------------------------------------------------------------
    \3\ See Exhibit 43, which appears in the Appendix on page 641.
---------------------------------------------------------------------------
    Mr. Schneider. I don't know, Mr. Chairman.
    Senator Levin. Do you know, Mr. Beck?
    Mr. Beck. I don't recall precisely----
    Senator Levin. How about approximately?
    Mr. Beck. Half.
    Senator Levin. Was it about a billion-and-a-half?
    Mr. Beck. Half.
    Senator Levin. It was about half. So we will say about a 
billion-and-a-half of the $3 billion. Do you know which were 
sold and which weren't?
    Mr. Beck. No.
    Senator Levin. OK. Now, the reason that Option ARM loans 
were selected is because they were most likely to go 
delinquent. The market was not yet aware of it. Did you notify 
investors when you securitized Option ARM loans into the RMBSes 
that the delinquency rates for several WaMu securities had gone 
up--were expected to go up? Did you notify the investors?
    Mr. Beck. Mr. Chairman, the market was keenly aware.
    Senator Levin. Do you know whether investors were notified?
    Mr. Beck. Investors were notified of the risk 
characteristics of the loans.
    Senator Levin. Were they notified that there was a billion-
and-a-half dollars in loans that were selected because they 
were Option ARMs and that it was your expectation that Option 
ARMs were going to go delinquent in greater numbers? Were they 
notified specifically of your findings?
    Mr. Beck. No.
    Senator Levin. Now, those Option ARMs, at least the ones 
that are called WMALT 2007, OA3--that is Exhibit 1g,\1\ if you 
will take a look at it--they show the delinquency rates for 
many, or a number of WaMu securities. That ARM, which is where 
you put these delinquency-prone Option ARMs--and by the way, 
Option ARMs are supposed to be prime--but these delinquency-
prone Option ARMs now--you won't be able to see that. You will 
have to look in your book. That is Exhibit 1g. They now have a 
delinquency rate of more than 50 percent, which means more than 
half of the underlying loans are now delinquent. More than a 
quarter of the underlying mortgages are in foreclosure.
---------------------------------------------------------------------------
    \1\ See Exhibit 1g, which appears in the Appendix on page 221.
---------------------------------------------------------------------------
    Mr. Beck, purchasers of securities were relying on you as 
an underwriter to provide complete and truthful information. Is 
that correct?
    Mr. Beck. Yes, they are.
    Senator Levin. Complete and truthful information?
    Mr. Beck. Yes.
    Senator Levin. Did the investors know everything that you 
knew about these expected high delinquencies?
    Mr. Beck. Mr. Chairman, the risk characteristics that Mr. 
Shaw----
    Senator Levin. No. Were they notified? I am asking you a 
specific question. You had an expectation that Option ARMs in 
your inventory were going to have a high delinquency rate. You 
based that on an assessment that you made. You did a study. 
Were the investors notified that WaMu did its own analysis to 
identify Option ARMs that had a propensity to go delinquent?
    Mr. Beck. Mr. Chairman, I am not even sure that the loans 
that Mr. Shaw identified got into the sale transaction.
    Senator Levin. Do you know whether they did or didn't?
    Mr. Beck. I do not.
    Senator Levin. Should you?
    Mr. Beck. I am not sure whether the loans that Mr. Shaw 
identified----
    Senator Levin. Should you know? Should you have known? 
Look, you are being told that your Option ARMs have a real high 
propensity for delinquency. You write emails back and forth--
high delinquency, fear of delinquency. You identify those 
Option ARMs. First you identify the risks. Three billion 
dollars is authorized; a billion and a half of Option ARMs from 
that inventory are sold. You have done a study. You know the 
propensity. You have an obligation to tell your purchasers as 
an underwriter complete and truthful information.
    Did your investors know of your high delinquency 
expectation? Do you know?
    Mr. Beck. Mr. Chairman, it is important when I answer this 
question to understand that, as you pointed out, this is the 
beginning of 2007. The subprime market is pretty much shut 
down, and delinquencies are rising very fast in that space and 
in the prime space. And as Mr. Cathcart pointed out in the 
earlier testimony, because we cannot sell loans, they are 
coming back onto the balance sheet and using up capital, and 
delinquencies are rising, so our loan loss reserves are going 
up.
    So one alternative to help raise capital would be to sell 
loans from our Option ARM portfolio.
    Senator Levin. Look, Mr. Beck, those emails talk about 
delinquencies, delinquencies, delinquencies. You identified the 
delinquencies as coming from your Option ARMs. My question is a 
very specific question. You knew all this. They were 
identified. Did you notify people that were buying your 
securities that you had done a study of delinquencies in your 
Option ARMs? That is my question. Do you know?
    Mr. Beck. We did not--they do not have these emails. What 
they do have is a prospectus supplement that has all the risks, 
relevant risks, including what Mr. Shaw would have put in 
there. The FICOs, the geographies, the LTVs--all that 
information would have been in the prospectus supplement.
    Senator Levin. You are saying that the prospectus notified 
your investors that you had done a study of high----
    Mr. Beck. No, Mr. Chairman, I am not saying that.
    Senator Levin. And that you had determined that the first 
quarter's Option ARMs had a high risk of delinquency. And you 
are telling us you did not notify the investors of that study. 
You are telling us that you do not even know whether or not 
those Option ARMs ended up in the securities, whether that $3 
billion included those. And that was your responsibility to 
make sure that the securities which went out to the investors 
were following notice to the investors of everything that they 
needed to know in order that the information be complete and 
truthful. That is what your testimony is under oath.
    Mr. Beck. It is a very real possibility that the loans that 
went out were better quality than Mr. Shaw laid out.
    Senator Levin. And you do not----
    Mr. Beck. A very real possibility.
    Senator Levin. And there is a very good possibility that 
they were exactly the quality that he laid out? Is that right?
    Mr. Beck. That is right.
    Senator Levin. OK. And you do not know, and apparently you 
do not care, and the trouble is you should have cared because 
there is an obligation to make sure that your investors know, 
and they did not know what you knew, critical information that 
you knew. That is the problem.
    Senator Kaufman, do you want to----
    Senator Kaufman. Yes, I just want to see if I got this 
straight. On this list it shows that some of the high FICO 
loans are the very ones that have the highest delinquency 
rates. Is that right, the memo from Robert Shaw on February 20, 
Exhibit 41? So telling him that there was a high FICO really 
would be deceptive when you knew those were the units that were 
having the high delinquency rate, correct?
    Mr. Beck. Senator, could you repeat the question, please?
    Senator Kaufman. If you look at Exhibit 41 where Shaw lists 
options, he lists a bunch--he says that the FICO--increasing 
delinquencies among FICOs of 700 to 739 was an 1,197-percent 
increase, FICOs of 780 plus a 1,484-percent increase; FICOs of 
620 to 659, an 820-percent increase. So someone looking at the 
portfolio, the high FICOs were really the ones that were having 
an incredible increase in their delinquency rates. Is that 
fair?
    Mr. Schneider. Senator, they had a high increase in actual 
rates, but the actual rate was 0.4 percent, which means four 
out of 1,000.
    Senator Kaufman. Yes, but it was--well, why is the--for the 
7-2--4.2 billion?
    Mr. Schneider. That is the aggregate size of that pool. 
That is not the amount that is delinquent.
    Senator Kaufman. And what percentage of that would be 
delinquent?
    Mr. Schneider. That is 0.4 percent of the amount.
    Senator Kaufman. OK. Let me ask you one other question 
while we are on that. On the earlier memo, it showed there were 
FICO rates from 510 to 540.
    Mr. Schneider. What document are you on, Senator?
    Senator Kaufman. That is on the February 14, 2007--maybe I 
have this wrong, from Michael Liu to Richard Ellison. He lists 
the attached spread sheet with a total Option ARMs, it says 
$105 million in non-accrual between FICO 501 to 540.
    Mr. Schneider. Senator, which document?
    Senator Kaufman. The page that ends 135, Exhibit 40b.\1\ 
The last page.
---------------------------------------------------------------------------
    \1\ See Exhibit 40b, which appears in the Appendix on page 632.
---------------------------------------------------------------------------
    Mr. Schneider. Yes, Senator. Once a loan goes into non-
accrual, goes delinquent, its credit score gets impacted very 
significantly, so that would not be a surprise, nor would it be 
indicative of what the loan was originated at.
    Senator Kaufman. So you mean after it goes delinquent, then 
the FICO score for the person that borrowed it drops, and this 
shows their FICO score after the delinquency, not at the time 
they apply for the loan.
    Mr. Schneider. That is correct.
    Senator Kaufman. OK. Thank you.
    Senator Levin. I think I just have one additional question. 
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.
    Senator Levin. So they may have been given a long list of 
characteristics of loans, but they were not informed that loans 
with those or some of those characteristics, according to a 
WaMu analysis, had a greater propensity towards delinquency. Is 
that correct?
    Mr. Beck. Yes.
    Senator Levin. OK. Do you have anything else?
    Senator Kaufman. Yes. Mr. Beck, you said that at this point 
most people knew that the subprime mortgage market was in 
pretty bad shape. What was the psychology of the people buying 
mortgage-backed securities at that point if they knew that this 
was a pretty bad situation? Which I think by then they did.
    Mr. Beck. They did, but they did not know how bad it was 
ultimately going to get, and so at that point in time, they 
were demanding wider margins for the securities that they 
bought, but had not stopped buying them yet.
    Senator Kaufman. OK. Thank you.
    Senator Levin. You made reference to the subprime market 
going down. Option ARMs are prime. They are not subprime, 
right? They are supposed to be prime mortgages. Isn't that 
correct?
    Mr. Beck. Yes.
    Senator Levin. Thank you both. You are excused. We 
appreciate your being here.
    We will go to our third panel. Does our reporter need a 
break? I was hoping you would say yes. I will not ask our media 
whether they need a break or not.
    We are going to take a 10-minute break. We are going to 
resume at 2:30 p.m.
    [Recess.]
    Senator Levin. We will come back into session now, and we 
will call our final panel of witnesses for the hearing: Stephen 
Rotella, the former President and Chief Operating Officer of 
Washington Mutual Bank; and Kerry Killinger, the former 
President, CEO, and Chairman of the Board of Washington Mutual. 
We appreciate both of you being with us this afternoon and look 
forward to your testimony. As you have no doubt heard, we have 
a rule, Rule VI, that requires all witnesses who testify before 
our Subcommittee to be sworn, and at this time, I would ask you 
both to please stand and raise your right hand.
    Do you swear that the testimony you are about to give to 
this Subcommittee will be the truth, the whole truth, and 
nothing but the truth, so help you, God?
    Mr. Rotella. I do.
    Mr. Killinger. I do.
    Senator Levin. The timing system will be the same that I 
believe you heard, but it means that a minute before the red 
light comes on, you will see the lights change from green to 
yellow. That will give you an opportunity to conclude. Your 
written testimony will be made part of the record in its 
entirety. We would ask that you try to limit your oral 
testimony to no more than 5 minutes, and, Mr. Rotella, I think 
we are going to have you go first, followed by Mr. Killinger.

TESTIMONY OF STEPHEN J. ROTELLA,\1\ FORMER PRESIDENT AND CHIEF 
           OPERATING OFFICER, WASHINGTON MUTUAL BANK

    Mr. Rotella. Thank you. Chairman Levin, Ranking Member 
Coburn, and distinguished Subcommittee Members, thank you for 
inviting me to testify and for sharing these remarks with you. 
This is my first public statement since the FDIC seized 
Washington Mutual in September 2008, so I want to be clear 
about the key factors that led to an elevated level of risk at 
WaMu during the financial crisis, risks that were created over 
many years prior to my arrival at WaMu in 2005.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Rotella appears in the Appendix 
on page 169.
---------------------------------------------------------------------------
    I also want to summarize how the team that I was a part of 
recognized those risks and made solid progress in proactively 
reducing them. 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 product, and subprime lending was up 52 percent. As the 
facts in my written statement to this Subcommittee show, those 
extraordinary rates ceased after 2005, and we then reduced 
total high-risk mortgage volume substantially every year after 
that.
    Total high-risk lending was not expanded and did not 
accelerate after 2005, as some have reported. The facts show 
the opposite.
    I provide my statement to you from my vantage point as a 
30-year veteran in financial services, from nearly 18 years at 
JP Morgan Chase, and as WaMu's chief operating officer for 3\1/
2\ years. When I joined WaMu in 2005, the company had over $340 
billion in assets. As a nationally chartered thrift, WaMu had 
already developed a high concentration of mortgage risk 
relative to more diversified banks. And as I noted, the company 
had been accelerating its growth in higher-risk mortgage 
products and, in addition, it had serious operating 
deficiencies, particularly in mortgage lending.
    WaMu's concentration risk was particularly acute because 
nearly 60 percent of its mortgage loans were from California 
and Florida, which had experienced large and unsustainable home 
price increases. What happened at WaMu was principally the 
combined effect of those risks developed over almost two 
decades, which would be magnified and stressed by the extreme 
market conditions of late 2007 and 2008.
    The team that I was a part of worked very hard to adjust to 
a rapidly changing environment and addressed those risks. As 
public data shows, we reduced the absolute size of WaMu's 
mortgage business, including new production, total high-risk 
lending, and its portfolio every year after 2005 and by a 
substantial amount in aggregate. We made progress in 
diversifying the company and had plans to do more, but there 
simply was not enough time to complete the enormous 
transformational change needed in a $340 billion thrift given 
the collapse of the housing market roughly 2 years after we 
started.
    In fairness to all concerned, few experts, including the 
Chairman of the Federal Reserve Board and the Secretary of the 
Treasury, anticipated what occurred in the housing market and 
the economy as a whole. Now, I would like to provide you with a 
bit more detail about WaMu.
    Prior to 2005, when I joined the company, WaMu had been 
growing its mortgage business at an accelerating rate. By 2003, 
it was the No. 2 mortgage lender with a market share of over 11 
percent, and its subprime volume had been growing by nearly 50 
percent every year from 2001 forward until 2005. WaMu's stated 
strategy was similar to many firms with large mortgage units 
during the pre-crisis economy. With the benefit of hindsight, 
that strategy was ill advised.
    As the financial crisis conclusively established, credit 
risk was mispriced for a declining housing market. In 2003 and 
2004, the company's mortgage business experienced very serious 
risk management and operating missteps. A management shake-up 
ensued, and it was around this time that a new executive team 
began to take shape, including my hiring in 2005. That team 
believed that with enough time and effort, WaMu could resolve 
its issues and take its place among the country's finest 
financial institutions. I and others recognized that due to 
WaMu's combination of risks, changes needed to be made. As the 
market softened, we began to migrate the company away from its 
mortgage legacy. By the end of 2005, we were making solid 
progress, and by the time of the seizure, WaMu's market share 
in mortgages had been cut by nearly two-thirds, from over 11 
percent to about 4 percent, and we had shut down Long Beach and 
Option ARM lending.
    Far from accelerating or expanding, as some large 
competitors did during this time, we were slowing and 
contracting faster than the market as a whole. Looking back 
now, of course, I would have tried to move even faster than we 
did in the areas where I had direct control. Unfortunately, 
after the capital markets stopped operating in the third 
quarter of 2007, we were unable to execute on aspects of our 
strategy.
    Subsequently, the decline in the housing market 
accelerated, and it was not long before the financial crisis 
was in full swing. We continued our efforts as the team raised 
capital, and, in fact, the day the company was seized, our 
primary regulator, the OTS, determined that WaMu was well 
capitalized. All of us wanted the opportunity to finish what we 
had started in 2005.
    I thank you for inviting me here today, and I look forward 
for your questions.
    Senator Levin. Thank you very much, Mr. Rotella. Mr. 
Killinger.

  TESTIMONY OF KERRY K. KILLINGER,\1\ FORMER PRESIDENT, CHIEF 
EXECUTIVE OFFICER, AND CHAIRMAN OF THE BOARD, WASHINGTON MUTUAL 
                              BANK

    Mr. Killinger. Thank you very much, Mr. Chairman and 
Members of the Subcommittee. I very much appreciate the 
opportunity to contribute to your investigation of the 
financial crisis. In addition to my oral testimony, I have 
submitted extensive written testimony.
---------------------------------------------------------------------------
    \1\ The prepared statement of Mr. Killinger appears in the Appendix 
on page 179.
---------------------------------------------------------------------------
    I was an employee of Washington Mutual for more than 30 
years and was honored to be its chief executive officer for 18 
of those years. And thanks to the efforts of tens of thousands 
of our employees, the bank enjoyed many successes over most of 
that tenure as CEO. However, the financial crisis and the 
seizure of the bank in September 2008 were devastating to the 
company, its customers, employees, investors, and communities. 
And as CEO, I accept responsibility for all of our performance 
and am deeply saddened by and sorry for what happened.
    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. And we did not just talk about it, 
but instead we did some things about it.
    Unlike most of our competitors, we aggressively reduced our 
residential first mortgage originations by 74 percent, and we 
cut our home loan staffing in half between 2003 and 2007. Our 
market shares of prime and subprime loan originations declined 
by 50 percent over this period.
    We also deferred plans to grow many of our loan portfolios 
and instead returned capital to shareholders through share 
repurchases and cash dividends. We sold 30 percent of our loan 
servicing portfolio. We reduced and then eliminated broker and 
correspondent lending. We cut subprime and Option ARM 
originations dramatically in 2006 and 2007 and eliminated those 
products in 2008.
    Now, with the benefit of hindsight, had we known that 
housing price declines of 40 percent or more would occur in key 
markets served by the company, we would have taken even more 
draconian measures.
    Washington Mutual was a Main Street bank dedicated to 
serving everyday consumers. Most of our activities centered on 
providing checking, savings, investment, and credit card 
services to millions of customers. Our residential lending was 
a declining part of the company's business since 2003 and 
contributed only 13 percent of our company's revenues by 2007, 
and it was focused predominantly on prime borrowers.
    The company offered a full range of fixed- and adjustable-
rate products, and its portfolios performed well over many 
years, with loss rates significantly below 1 percent per year. 
Approximately 90 percent of the company's residential first 
loan portfolio had a loan-to-value at origination of 80 percent 
or less.
    Now, higher-risk residential products, like home equity, 
Option ARM, subprime loans, were not new or exotic, but had 
been successfully offered to customers for many years. Now, we 
entered the subprime business with our purchase of Long Beach 
Mortgage in 1999 to better serve an underserved market. This 
was a small and declining part of our business since 2005. 
However, due to growing concerns over the housing market and 
third-party mortgage brokers, as well as our own operating 
issues, we greatly reduced subprime originations in 2006 and 
shut down the business in 2007.
    We had well-defined and clear policies of fair dealing with 
customers, and our responsible lending principles were praised 
by community groups. Our regulator consistently assigned us the 
highest CRA rating of outstanding, and employees were expected 
to practice our core values, and violations led to reprimands 
and terminations. And this is why I am particularly angry when 
I read that any customer might have been sold an inappropriate 
product.
    Now, enterprise risk management was a vital activity for 
the company. In fact, I created a centralized enterprise risk 
management group in 2002 and well over 1,300 people were 
involved in that activity by 2007. The chief enterprise risk 
officer was placed on the executive committee and reported to 
the board that the group was adequately staffed and functioned 
effectively on a quarterly basis.
    Finally, Washington Mutual should not have been seized and 
sold for a bargain price, but should have been allowed to work 
its way through the financial crisis. The company suffered from 
rising loan losses, but we were working our way through the 
crisis by reducing operating costs, raising over $10 billion of 
additional capital, and setting aside substantial loan loss 
reserves.
    When I left the bank in early September 2008, capital 
greatly exceeded regulatory requirements for a well-capitalized 
bank, deposits were stable, sources of liquidity appeared 
adequate, and our primary regulator, the OTS, had not directed 
us to seek additional outside capital nor find a merger 
partner.
    So it was with shock and great sadness when I read of the 
seizure and bargain sale of the company in late September 2008. 
I believe it was unfair that the company was not given the 
benefits extended to and actions taken on behalf of other 
financial institutions. Within days of its seizure, the FDIC 
insurance limit was raised to $250,000. The FDIC guaranteed 
bank debt. The Treasury Department announced favorable 
treatment of tax losses. The Federal Reserve purchased assets 
and injected massive liquidity into the system. And the TARP 
program added hundreds of billions of new capital to banks. 
These measures would have been extraordinarily helpful to 
Washington Mutual, just as they were to all other banks.
    And the unfair treatment of the company did not begin with 
its unnecessary seizure. In July 2008, the company was excluded 
from the ``Do Not Short'' list, which protected many Wall 
Street banks from abusive short selling. The company was 
similarly excluded from the hundreds of meetings and telephone 
calls between Wall Street executives and policy leaders that 
ultimately determined the winners and losers in this financial 
crisis. For those that were part of the inner circle and were 
too clubby to fail, the benefits were obvious. For those of us 
outside of the club, the penalty was severe.
    Now, I have some other suggestions for regulatory reform in 
my written statement that I would be happy to discuss further, 
but thank you, and I look forward to answering your questions. 
And I do request, Mr. Chairman, that my complete statement and 
any documents referenced in it through this morning be placed 
into the written record.
    Senator Levin. It will be placed in the record, as will all 
the opening statements. We will try a 20-minute first round 
here.
    First on the numbers. Mr. Killinger, in your opening 
statement you said that from 2003 to 2007, WaMu reduced its 
residential first mortgage originations, reduced its market 
share, and that may be accurate, but it is misleading in what 
it leaves out.
    You made a major shift in your strategy and you reduced 
your fixed-loan origination in 2003 by almost $200 billion. So 
most of the reduction in the mortgage business that you were 
engaged in came through the reduction in the fixed-loan 30-year 
mortgages that we see on that chart, Exhibit 1i.\1\
---------------------------------------------------------------------------
    \1\ See Exhibit 1i, which appears in the Appendix on page 223.
---------------------------------------------------------------------------
    Then if you look at Chart 1c, Exhibit 1c in your book,\2\ 
you will see that the securitization of your subprime home 
loans continued to climb right through 2006.
---------------------------------------------------------------------------
    \2\ See Exhibit 1c, which appears in the Appendix on page 214.
---------------------------------------------------------------------------
    Now, you have said, I believe, that you reduced 
significantly the origination of these subprime loans, but is 
it not true that those numbers on Exhibit 1b \3\ are accurate, 
that in terms of securitizing you continued to securitize your 
subprime home loans right through 2006? Is that accurate?
---------------------------------------------------------------------------
    \3\ See Exhibit 1b, which appears in the Appendix on page 213.
---------------------------------------------------------------------------
    Mr. Killinger. Thank you, Mr. Chairman. You raise an 
excellent point, and----
    Senator Levin. Are my numbers accurate?
    Mr. Killinger. And I appreciate having the opportunity to 
make a clarification for the benefit of the Committee.
    Regarding the first chart, my data was correct that we had 
a 74-percent reduction in our origination from 2003 to 2007. 
Your point is correct that a significant part of that reduction 
was the decline in fixed-rate mortgage originations. However, 
that does not reflect a change in strategy or policy. That 
reflected low interest rates that were prevailing in 2002 and 
2003 that led to massive refinancings in the United States. And 
since I had been at the organization so many years, I can just 
back you up a couple of years prior to that----
    Senator Levin. I just wanted to----
    Mr. Killinger [continuing]. And products like the Option 
ARM would have been a very large percent of the total just 2 
years before that.
    Senator Levin. I just wanted to go over the numbers----
    Mr. Killinger. Part of what we are seeing here----
    Senator Levin. Excuse me for interrupting because we do not 
have that much time, but I just wanted to go into the numbers. 
The major reason for the reduction was the reduction in the 
fixed-rate number. Is that correct, whatever its cause?
    Mr. Killinger. Yes, that is right. I just wanted to be sure 
that we understood the primary cause was that the refinancing 
boom from 2002 and 2003 subsided in the other period.
    Senator Levin. Now, you also changed your strategy. What 
year was that?
    Mr. Killinger. 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 would hold on the balance sheet. We had that 
long-term strategy, but as I mentioned in my opening comments, 
we quickly determined that the housing market was increasing in 
its risk, and we put most of those strategies for expansion on 
hold. In fact, our subprime portfolio that we held in our 
portfolio actually declined from the time that we had that 
strategy versus the strategy which had that increasing in size.
    Senator Levin. In 2003, your subprime amount, according to 
your filings with the SEC, was $20 billion. It went up in 2004 
to $31 billion. It went up in 2005 to $34 billion, leveled back 
to $30 billion in 2006. That is your subprime, so it went 
actually up through 2005 and stayed high through 2006. Your 
fixed mortgage loans in 2003 were $263 billion. It drastically 
dropped in 2004 and 2005, to $77 and $78 billion, respectively. 
Your Option ARMs jumped from 2003 when they were $30 billion up 
to more than double in 2004, and in 2005 they also doubled what 
they were in 2003. So in terms of the direction you have 
dramatically increased your Option ARMs from 2003 to 2005. Even 
in 2006, they were more than they were in 2003. You 
dramatically dropped your fixed amount, and your subprime again 
almost doubled, not quite, from 2003 to 2005. Now, those are 
your SEC filings, and we will let them speak for themselves.
    Mr. Rotella, in your testimony you said that you did not 
design the strategy that was designed by the board, which was a 
higher-risk strategy. On page 4 and 5 of your testimony for the 
record, you said that prior to the time you joined WaMu in 
2005, the board of directors had established a 5-year strategic 
plan. This plan called for additional growth in the mortgage 
lending business with a particular emphasis on higher-margin 
and higher-risk products. That is your statement. Is that 
correct? That is what you found when you got there?
    Mr. Rotella. Yes, Mr. Chairman.
    Senator Levin. All right. Now, you also then said that the 
bank strategy, with the benefit of hindsight, was ill advised. 
You did not design the strategy that the Board had approved. 
But here is something else you said that I want to ask you 
about, that due to the state of the company's operations, which 
were weaker than you had anticipated before you joined WaMu, 
that you realized that changes to the strategy needed to be 
implemented. What did you mean by the company's operations were 
weaker than you had anticipated?
    Mr. Rotella. Mr. Chairman, when I was hired in 2005, the 
Chief Operating Officer position was a brand new position at 
WaMu. Part of the reason for that position being created were 
substantial problems that had come up in the mortgage business 
prior to my arrival. As I mentioned in my oral statement, in 
2003 and 2004, there were some substantial issues in market 
risk management. Mr. Vanasek earlier mentioned a systems 
project that had to be written off.
    And I just add at the end of my comment on this, the 
company bought a number of mortgage companies over the course 
of about 2000 through 2005. There were 12 mortgage origination 
systems when I joined. There were a number of servicing 
systems. The operation needed a lot of work.
    Senator Levin. OK. During the prior panels, we went through 
a number of documents and audit reports describing problems 
with Long Beach. If you will take a look at Exhibit 8b,\1\ 
please, page 3. This is a joint report in 2004 by the FDIC and 
the State of Washington after a visit to WaMu in 2003. And here 
is what it said about Long Beach.
---------------------------------------------------------------------------
    \1\ See Exhibit 8b, which appears in the Appendix on page 389.
---------------------------------------------------------------------------
    ``40% . . . of the 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.'' That is 950 of the 
4,000. ``800 were deemed unsaleable, and the remainder 
contained deficiencies requiring remediation prior to sale.''
    Do you remember those problems at Long Beach in 2003, Mr. 
Killinger?
    Mr. Killinger. Yes.
    Senator Levin. And then you halted the securitizations 
until the problems were cleared up. But they began again in 
2004. But by 2005, the problems started erupting again with a 
surge of early payment defaults. WaMu ended up repurchasing 
almost $1 billion in loans, suffered a $100 million loss. Why 
didn't you halt the securitizations in 2005 when those problems 
again appeared?
    Mr. Killinger. Well, again, Senator, we entered Long Beach 
Mortgage, as you know, back in 1999 to help better serve that 
community. When we--it was a relatively very small--part of our 
business, and when they first encountered some of the 
securitization problems or some of the loan quality, we sent a 
team in to work on that. We believed that they had made 
substantial progress with that.
    And then they started to increase the originations again 
because we felt that the operational issues were under control. 
And then we started to see some additional evidences of 
difficulties there. The actions that we took were to change out 
managements, to go in and do some organizational redesign to 
get to a point where we felt comfortable that we could proceed 
with doing both the whole loan sales and the securitizations 
that the company did.
    Senator Levin. Let us talk about those years where you got 
comfortable. Mr. Rotella, take a look at Exhibit 11,\1\ if you 
would. This is an email chain from April 2006 between you and 
Mr. Killinger. You describe the situation at Long Beach. This 
is April 2006.
---------------------------------------------------------------------------
    \1\ See Exhibit 11, which appears in the Appendix on page 414.
---------------------------------------------------------------------------
    ``The major weak point was the review of Long Beach. . . . 
delinquencies 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.'' Then you cite a 
number of factors for why the problems should be solved.
    Five months later, you sent Mr. Killinger another email 
about Long Beach, which we have marked Exhibit 12,\2\ if you 
want to look at that. In this email chain from September 2006, 
you wrote Mr. Killinger the following. ``Long Beach is 
terrible, . . . Repurchases, [early payment defaults], manual 
underwriting, very weak servicing/collection practices, and a 
weak staff.'' You said that you were addressing the problems.
---------------------------------------------------------------------------
    \2\ See Exhibit 12, which appears in the Appendix on page 415.
---------------------------------------------------------------------------
    But the problems didn't get addressed. A year later, now 
August 20, 2007, and the audit of Long Beach loan origination 
and underwriting. This is Exhibit 19.\3\ If you look at page 3 
of Exhibit 19, here is what it says. It is basically the same 
old problems. ``Repeat Issue,'' so this is a repeat issue, 
``Underwriting guidelines established to mitigate the risk of 
unsound underwriting decisions are not always followed. . . . 
accurate reporting and tracking of exceptions to policy does 
not exist. . . .''
---------------------------------------------------------------------------
    \3\ See Exhibit 19, which appears in the Appendix on page 462.
---------------------------------------------------------------------------
    So that takes us up to August 20, 2007. So now let me ask 
you, Mr. Rotella, why did these problems exist year after year? 
What is the explanation for that?
    Mr. Rotella. Mr. Chairman, just by way of background, when 
I was with JP Morgan Chase, I ran a small subprime business, 
relative to Long Beach. When I joined in 2005, my initial focus 
was on the main home loans business. I shortly became very 
concerned about Long Beach around the middle of 2005. We have 
heard a couple of times, management was relieved of their 
duties. That was my recommendation and responsibility. At the 
end of 2005, the folks that were running Long Beach were either 
asked to leave or left. I transferred that business at the 
beginning of 2006 into the main Home Loans Unit under a group 
of people who were better equipped to run it and we went about 
a process to try to improve that company.
    In addition, while we were doing that, 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.
    So from my perspective as the Chief Operating Officer, 
taking out management, restructuring the business, bringing 
down volume, and ultimately shutting it down was a proactive 
number of steps.
    Senator Levin. August 2007, if you will look at Exhibit 
79,\1\ page 2. Now we are in August 2007--here is what you 
write. ``[Home loans] (the original prime only)--was the worst 
managed business I had seen in my career.'' This isn't just 
Long Beach. ``That is, until we got below the hood of Long 
Beach.'' Even before you got to Long Beach, you said that home 
loans, which was part of WaMu, was the worst managed business 
that you had seen in your career. So what were the problems 
with the home loans management?
---------------------------------------------------------------------------
    \1\ See Exhibit 79, which appears in the Appendix on page 793.
---------------------------------------------------------------------------
    Mr. Rotella. Mr. Chairman, there was a reason I was hired 
after 18 years of experience at JP Morgan Chase. As I said 
earlier, the company, and this was well known in the industry, 
in the mortgage business, had experienced significant problems 
in 2003 and 2004. The problems in the main home loans group, 
which is where I focused a lot of my initial attention, were 
several.
    The first I would mention is the management team did not 
have a great deal of experience in running a mortgage company 
that size. I went through a process, along with David 
Schneider, who joined later in the year, of repopulating most 
of the senior jobs in that business.
    Second, the technology in the business was antiquated, and 
as I said earlier, there were literally 12 different production 
systems as a result of many acquisitions. There were manual 
processes in the business, and relative to what I had seen at 
my previous employer, the company had many shortcomings as it 
related to processing, closing, and servicing loans.
    Senator Levin. Now, I think you were here earlier this 
morning when we went through with prior panels the 2005 
internal WaMu investigation of the two Southern California loan 
offices, Montebello and Downey. It found extensive rates of 
fraud affecting their loans, rates of 83 percent and 58 
percent. That was all on Exhibit 23b,\2\ if you want to refer 
to that.
---------------------------------------------------------------------------
    \2\ See Exhibit 23b, which appears in the Appendix on page 511.
---------------------------------------------------------------------------
    We have also reviewed a memorandum, which is Exhibit 24,\3\ 
which was prepared in 2008 after the frauds and evidence of it 
resurfaced. It found that virtually no actions had been taken 
following the 2005 investigation, and after reviewing the loans 
by Montebello in 2007 found that 62 percent contained 
fraudulent information.
---------------------------------------------------------------------------
    \3\ See Exhibit 24, which appears in the Appendix on page 515.
---------------------------------------------------------------------------
    So year after year after year, we have a couple parts of 
your company that are apparently engaged in seriously 
fraudulent loans with misinformation that is pervasive. So 
starting in 2005, why weren't any actions taken after that 
first 2005 review?
    Mr. Rotella. In the particular case of the 2005 review, I 
was not aware of that at the time. I was aware of the 2008 
review that you referenced earlier that came through one of our 
mortgage insurers. And I would simply say, Senator, as 
president of the company with 40,000 employees, first of all, 
all fraud is bad and any instance of fraud that was brought to 
my attention would be turned over to internal audit and/or 
legal to do a separate review. And if they came back and told 
me that there indeed was fraud, believe me, significant action 
would be taken.
    Senator Levin. Well, somebody didn't tell you about it. Is 
that what you are saying? You didn't know----
    Mr. Rotella. I am not aware of the 2005 situation, at the 
time.
    Senator Levin. Somebody didn't tell you about it?
    Mr. Rotella. No, sir.
    Senator Levin. These are very serious allegations. These 
are high fraud rates. Now, who should have told you about it?
    Mr. Rotella. That would normally come from the business or 
from the audit or legal department.
    Senator Levin. And the first you heard of that was when?
    Mr. Rotella. I became aware of this particular situation 
when it was brought to my attention in 2008----
    Senator Levin. That is the first----
    Mr. Rotella [continuing]. As was referenced in your 
documents from later in the binder.
    Senator Levin. Now, in 2007, we had a review. This is 
Exhibit 21.\1\ This went to you, also. This was now a problem 
that corporate credit review did. High risk: ``Ineffectiveness 
of fraud detection tools,'' and ``Weak credit risk 
infrastructure impacting credit quality.'' They looked at 187 
loans they were reviewing. Of the 187 files that were looked 
at, of those 132 that were sampled were identified with ``red 
flags that were not addressed by the business unit.'' Eighty 
had stated income loans that were identified as being 
unreasonable. Eighty-seven ``exceeded program parameters.'' And 
133 had ``credit evaluation or loan decision errors present.''
---------------------------------------------------------------------------
    \1\ See Exhibit 21, which appears in the Appendix on page 477.
---------------------------------------------------------------------------
    And this was sent to you, according to the cover sheet 
here, Mr. Rotella, Exhibit 21. Do you remember this one?
    Mr. Rotella. I do.
    Senator Levin. Well, you said you had found out about it in 
2008 for the first time. This is 2007.
    Mr. Rotella. Senator, this report labeled ``Wholesale 
Specialty Lending'' is about the subprime business. By August 
2007, we had shut that business down. This audit report is 
reflective of the actions that I took, which were to relieve 
management of their duties, take the volume down, and 
ultimately shut this business down by the time this was issued.
    Senator Levin. But you said you first became aware of fraud 
in 2008 and this shows significant fraud in 2007.
    Mr. Rotella. I was referring to the two California retail 
offices from Montebello and Downey when I mentioned 2008.
    Senator Levin. If you take a look now at Exhibit 33.\2\ 
This is a report by Radian Guaranty, which insured some of 
WaMu's mortgages. They reviewed a number of 2007 loans to 
evaluate the underwriting and compliance with their guidance. 
They found so many problems that it rated WaMu's loan files 
unacceptable, if you will look at page 2 on Exhibit 33.
---------------------------------------------------------------------------
    \2\ See Exhibit 33, which appears in the Appendix on page 553.
---------------------------------------------------------------------------
    Now, just one of the loan examples. I am picking one from 
page 5, but there are many. This is a $484,000 loan given to a 
sign designer. That is somebody who designs signs, who claimed 
to be making $34,000 a month in income. And this is what the 
report said. ``Borrower's stated monthly income of $34,000 does 
not appear reasonable. . . .'' It noted another problem. The 
loan file appraised the house at $575,000, but another report 
said the probable value was $321,000, an amount less than the 
loan. That is just one of the loans that Radian found 
unacceptable and uninsurable.
    Were either of you aware of the Radian report? Mr. Rotella, 
were you aware of it?
    Mr. Rotella. No, sir.
    Senator Levin. Were you aware of it, Mr. Killinger?
    Mr. Killinger. No.
    Senator Levin. Now, look at Exhibit 30.\1\ We have 
discussed this before. This is a Significant Incident 
Notification. It related to early payment defaults at the 
Westlake Village Home Loan Center, and it said that, in this 
report, Exhibit 30, it said that ``One Sales Associate admitted 
that during that crunch time some of the Associates''--some of 
the associates--``would `manufacture' asset statements from 
previous loan documents and submit them to the [loan processing 
center]. She said the pressure was tremendous from the [loan 
processing center] to get them the documents, since the loan 
had already funded and pressure from the Loan Consultants to 
get the loans funded. All the Sales Associates stated that''--
the loan officers--``did not instruct them to falsify 
documentation and just told them to get the loans funded with 
whatever it took.''
---------------------------------------------------------------------------
    \1\ See Exhibit 30, which appears in the Appendix on page 544.
---------------------------------------------------------------------------
    Exhibit 31,\2\ an internal investigative report about the 
same incident, says that ``Sales Associates would take [asset] 
statements from other files and cut and paste the current 
borrower's name and address.''
---------------------------------------------------------------------------
    \2\ See Exhibit 31, which appears in the Appendix on page 546.
---------------------------------------------------------------------------
    Were you aware, first, Mr. Rotella, that WaMu employees 
were cutting corners and even engaging in fraud to meet volume 
demands?
    Mr. Rotella. No, sir.
    Senator Levin. Were you aware, Mr. Killinger?
    Mr. Killinger. No, sir. That is an absolute violation of 
the code of conduct of the company.
    Senator Levin. I am sure it is, but were you aware of it? 
That is my question. That investigative report, Exhibit 31, 
were you aware of that investigative report?
    Mr. Killinger. In regarding Westlake, I believe it was 
prior to this particular report, I had someone give me a call 
and a tip that there might have been an issue at that office. I 
immediately forwarded that information to our internal audit, 
who did an investigation on that, and I turned it over to them 
for that investigation.
    Senator Levin. In terms of that specific exhibit, though, 
were you aware of that? Had you seen that?
    Mr. Killinger. I do not recall this specific exhibit.
    Senator Levin. Thank you. Senator Kaufman.
    Senator Kaufman. Mr. Killinger, you seem to have some 
opinions about why WaMu was seized. Why do you think WaMu was 
seized? I know it was after you were gone?
    Mr. Killinger. As I mentioned in my comments, I think 
Washington Mutual was very well positioned with its capital and 
operating plan to work itself through this financial crisis and 
I think it was making excellent progress on that. And I think 
that it was seized, in my opinion, in an unnecessary manner. 
Clearly, there was a lot of pressure on the financial system 
and regulators and policy leaders at that point in time in the 
wake of the collapse of Lehman. However, I just don't think the 
company was treated in the same equal-handed, fair manner that 
all other financial institutions were.
    And it is very much like oxygen--I will use an analogy of 
oxygen. None of us can live if oxygen is choked off for a brief 
period of time, and liquidity is that equivalent in financial 
services. Liquidity did start to become tight, not just for 
Washington Mutual, but for the entire industry for a brief 
period of time. But policy leaders elected to open up those 
tubes of oxygen for most banks and gave them a huge amount of 
benefits and Washington Mutual inexplicably, in my opinion, was 
not allowed to have the benefits of having that oxygen come to 
them for that brief period of time.
    And now, in hindsight, we can see for those that were able 
to get through that brief period and start to get back on the 
mend that the financial position is just extraordinarily 
different today than it was 12 months ago, and I believe 
Washington Mutual could have and should have been able to be 
one of those surviving banks.
    Senator Kaufman. Why was Washington Mutual specifically? I 
mean, is it just bad luck?
    Mr. Killinger. Well, I think there is just an element of 
timing.
    Senator Kaufman. I mean, why was it Washington Mutual? The 
others were given the oxygen. You were not. Why was that, do 
you think?
    Mr. Killinger. Well, obviously, I have had a chance to 
think about this for an extended period of time after having 
been away and it just doesn't look fair to me. And I think that 
the company was not treated fairly earlier in the year when it 
was excluded on that ``do not short'' list. By removing the 
target from the backs of other banks, it put the target on the 
back of Washington Mutual. I don't think Washington Mutual was 
treated fairly when the hundreds of telephone calls and 
meetings took place between Wall Street executives and policy 
leaders to decide the fate of how things would work. Washington 
Mutual was excluded from those meetings.
    And then I think it is just inexplicable that Washington 
Mutual gets quickly seized, and then within a matter of just a 
few days, all of these other measures that gave their lifeblood 
to the rest of the industry took place. And I just think those 
are unfair things and I wanted to speak about that on behalf of 
all of my fellow and past employees and investors who I think 
were harmed as a result of that.
    Senator Kaufman. I mean, do you think Wall Street banks 
were given preference by the regulators?
    Mr. Killinger. Well, in hindsight, you look at the position 
we were in and we made a decision to overnight, instantly, give 
Wall Street banks access to becoming bank holding companies and 
access to the Federal Reserve for liquidity. We very quickly 
passed the various legislation that increased the FDIC 
insurance limit to $250,000 and had the FDIC guarantee bank 
debt. That would have been huge for Washington Mutual. They 
injected the TARP money across the board. There were many 
banks, particularly Wall Street banks, that liquidity was a 
major issue for them and they were saved by this.
    Senator Kaufman. What was your relationship with the 
regulators before this? Did you have a good relationship with 
the regulators?
    Mr. Killinger. We worked very closely with our regulators. 
I think we had frequent meetings with the OTS. As I indicated 
in my comments, at the time I left, which was in early 
September 2008, we had not been directed to raise any 
additional capital. We had not been directed to seek a merger 
partner. So it is almost incomprehensible to me that 2 weeks 
later, the company--or 3 weeks later, that the company is 
seized.
    Senator Kaufman. Did you ever meet during 2008 with Mr. 
Paulson or Mr. Bernanke?
    Mr. Killinger. I met with Mr. Bernanke on a couple of 
occasions because I was a member of the Thrift Industry 
Advisory Council, which meets actually three times a year with 
the Federal Reserve. I did not meet personally with Mr. 
Paulson. I did talk to Mr. Paulson on the phone.
    Senator Kaufman. OK. Let me ask you some other questions. 
Stated income loans is kind of an unusual thing for me. I am 
kind of new at this. What is a stated income loan?
    Mr. Killinger. Well, as I think we heard this morning, 
stated income loans are loans in which information is put on an 
application where a customer tells us what their income is and 
then it is not verified.
    Senator Kaufman. And how did it develop?
    Mr. Killinger. Again, that product or that feature has been 
around for many years. I think what we are all dealing with is 
the housing crisis, or the housing boom grew and as competition 
grew, the use of limited documentation and no documentation 
kind of loans certainly expanded. And as we were commenting 
earlier, as we became more concerned that the housing market 
had increased in risk, I think that is one of the elements we 
all started to take a look at. So in our case, we started to 
cut back on our originations. We eliminated some of the product 
offerings. We tightened underwriting. As I heard from David 
Schneider earlier this morning, at one point, we also decided 
that limited documentation loans were not appropriate.
    Senator Kaufman. And what size mortgages were stated income 
loans used for at WaMu?
    Mr. Killinger. Again, I don't have direct knowledge. What I 
heard this morning is that most loan categories could be done 
with that.
    Senator Kaufman. And when a stated income loan was resold, 
did the bank disclose that a loan was made without verification 
of borrower income? Do you know?
    Mr. Killinger. I have no knowledge about what was put in 
disclosures or anything in our securitizations. That was done 
by our Capital Corp. and I was simply just not involved in any 
of those.
    Senator Kaufman. OK. Do you think people were actually 
lying about their income on these stated income loans?
    Mr. Killinger. Well, clearly, it is speculation because I 
just don't know. I am certainly very disappointed to think 
about my customers lying to me because that is fraud and it 
shouldn't happen. But I think an objective look at things is 
that there must have been situations where people did not tell 
the truth on their applications.
    Senator Kaufman. Mr. Rotella, would you be surprised if 
people were lying on these stated income loans?
    Mr. Rotella. Senator, I believe given the expansion of 
stated income lending in the marketplace in general, it would 
be naive to think that there weren't some who didn't.
    Senator Kaufman. Do you have reason to believe that WaMu's 
internal controls are sufficient to deter fraud in these kind 
of products?
    Mr. Rotella. Well, as I said earlier, Senator, all fraud is 
bad and there is fraud in all financial products. I have seen 
that throughout my career. As I said, related to WaMu's 
operating weaknesses, there were certain tools, at least when I 
got there and even at the end, we were trying to implement to 
help us identify fraud. There are automated tools and various 
techniques you can use. WaMu was behind the curve when I joined 
and we were making strides to get better at it, but by no means 
were we perfect.
    Senator Kaufman. Why did you decide to stop stated income 
loans, either one of you? Mr. Killinger, why did you stop doing 
them?
    Mr. Killinger. Well, again, market conditions changed very 
dramatically with housing prices coming down and there are a 
number of things that we changed. As you heard this morning, we 
tightened underwriting. We changed loan products. We ceased 
offering some of the subprime products. We ceased offering 
Option ARMs. We started to go back to more documentation on the 
loans. And there were just a number of things that became more 
appropriate because the housing conditions changed so 
dramatically.
    Senator Kaufman. So it was just right then when you really 
found out how bad stated loans were?
    Mr. Killinger. Well, I think, again, these are evolutionary 
processes and as it became more evident to us that the housing 
downturn was going to be greater than we initially thought, we 
took incrementally more actions.
    Look at it, as I mentioned in my comments, 2 years ago, we 
were one of the first in our peer group to be out there saying 
we are worried about housing. We are going to reduce what we 
are doing. Do you know how tough it is--well, of course you 
do--to be the only major player laying off thousands of 
employees and having to think about their families and what 
they are doing----
    Senator Kaufman. But you can understand that people would 
be concerned that when this thing went down, kind of the old 
thing from Watergate, what did you know and when did you know 
it, because these were being packaged up into mortgage-backed 
securities. So it is really kind of relevant, I think, to 
figure out when did these things happen. If, in fact, stated 
loans were bad, people knew they were bad, and then just went 
ahead and packaged them up into mortgage-backed securities, you 
are passing it along to someone else and there is fraud 
involved in that. So I am not just talking about WaMu, but you 
can--I mean, I am not missing something here, am I, here?
    Mr. Killinger. No. All I can talk about is what we did 
and--
    Senator Kaufman. Yes.
    Mr. Killinger. When I got concerned, we started pulling 
back our operations. We reduced these originations. We cut our 
market shares. We started to go in these directions. I didn't 
know there was going to be a 40 percent decline in housing 
prices.
    Senator Kaufman. Right.
    Mr. Killinger. Even in the middle part of 2007, Secretary 
Paulson was saying, I think this housing thing is contained and 
it is not really going to impact the overall economy and lead 
us into a recession. Chairman Bernanke was saying something 
similar about the containment of the subprime issues. So it 
really wasn't until that second half of 2007 when it became 
pretty obvious to us that things were going to be pretty 
difficult and we needed to pull in our horns even more.
    Senator Kaufman. But all these registered security deals, 
you had to sign them as a CEO, right?
    Mr. Killinger. No, sir.
    Senator Kaufman. You did not?
    Mr. Killinger. No.
    Senator Kaufman. Who did sign them, do you know?
    Mr. Killinger. Again, I was not directly involved in any of 
our securitizations or those securities, so----
    Senator Kaufman. Let me ask you about FICO, because we 
talked about that earlier. WaMu used FICO scores, right?
    Mr. Killinger. Yes.
    Senator Kaufman. And are they a good indicator of 
creditworthiness?
    Mr. Killinger. Well, historically, the two best indicators 
of a loan performance was loan-to-value ratio and FICO score, 
and those did a pretty good job of predicting how a loan would 
perform. There were other factors, such as the amount of income 
that somebody had and their ability to cover the debt. There 
were indicators about full documentation, limited 
documentation, adjustable rate, fixed rate, conforming, non-
conforming, a lot of things that also impacted. But the two 
most important were loan-to-value and FICO.
    What changed in this cycle is this whole thing about 
housing prices declining by 40 percent or more. As you heard, I 
think, this morning, all of a sudden, people faced with being 
underwater in their mortgages, and guess what, even if they had 
a decent FICO, their propensity to become delinquent was much 
greater.
    Senator Kaufman. So you don't think any of this had to do 
with kind of an explosion that mortgage-backed securities were 
great, people were making a lot of money on them, people that 
originated them making money on them, brokers were making money 
on folks, and Wall Street was making money on it, and that is 
what caused the explosion in mortgage-backed securities and 
that is part of the problem? It was just the fact that the 
housing market finally stopped?
    Mr. Killinger. Well, I think they are different topics and 
certainly somewhat interrelated. I made a comment in my written 
testimony that there is no simple or single cause of what went 
on----
    Senator Kaufman. No, I am just saying that was part. I am 
not saying there is any one single cause.
    Mr. Killinger. Yes.
    Senator Kaufman. I am just saying that was part of it. I 
think that at least the literature keeps saying that as this 
thing grew and got more and more profitable, people kind of 
reached out a little bit further and stretched things a little 
more. Where maybe something like stated loans may be OK for a 
while, people just started taking and using it as a tool in 
order to get into more mortgage-backed securities so they could 
feed this gigantic machine that was so incredibly profitable to 
everybody involved.
    Mr. Killinger. Well, there is no question that there was a 
tremendous growth of capital coming in from Wall Street and 
interest in this business and the GSEs----
    Senator Kaufman. Right.
    Mr. Killinger [continuing]. And that increasingly put 
pressure, competitive pressures on everybody to adjust loan 
terms.
    Senator Kaufman. But doesn't at that point the compensation 
also help, the fact that you were--you set the compensation, 
right? You were part of the process that set the compensation 
for the folks out there generating the loans, right?
    Mr. Killinger. Yes, we did, although I will tell you that 
people have--mortgage representatives have been paid on 
commission----
    Senator Kaufman. The commission, but we had----
    Mr. Killinger [continuing]. For many years.
    Senator Kaufman. We had a chart up here that showed that 
there was much more of a commission on the higher-risk, higher-
return products than there were on the lower-risk, lower-return 
products, right? \1\
---------------------------------------------------------------------------
    \1\ See Exhibit 3, which appears in the Appendix on page 278.
---------------------------------------------------------------------------
    Mr. Killinger. Yes, although, again, I am not intimately 
familiar because those were done within the business unit, but 
I also know those change each year and so you have got to look 
at what was it in each year and not necessarily just to one 
point in time.
    Senator Kaufman. OK. Do you know if the FICO scores in some 
of these, 550, I mean, do you know what the range was of 
Washington Mutual FICO scores?
    Mr. Killinger. Well, again, I don't have all the intimate 
knowledge, but I do know, because I followed what the bulk of 
the FICO scores were for our portfolios, and, for example, our 
Option ARM portfolio had an average FICO score slightly above 
700. Our home equity was slightly above 730. And our other--
prime residential, I think, was about 718 or so in that range. 
And I think in the case of Long Beach or the subprime portfolio 
we held in portfolio, it was somewhere in the mid-600s.
    Senator Kaufman. Now, you understand the problem with using 
averages, right?
    Mr. Killinger. I know it.
    Senator Kaufman. The barbell effect----
    Mr. Killinger [continuing]. An absolute barbell, but I 
don't have the barbell numbers in front of me.
    Senator Kaufman. Right. Yes.
    Mr. Killinger. That is the best I could give you.
    Senator Kaufman. But you do understand that using averages, 
that is what the rating agencies did, and clearly there were 
folks out there--I don't know, was Washington Mutual one of 
them that was using a barbell kind of distribution?
    Mr. Killinger. No. We had cells, matrices that show every 
FICO at every band and also against the loan-to-value against 
every one of those FICOs. I just don't have that detail.
    Senator Kaufman. Some of the information that some of the 
loans were being sold were clearly questionable, is that your 
feeling that everything that you sold while you were CEO of 
Washington Mutual, the vast majority of it was loans that 
weren't--you didn't know were delinquent? No one knew they were 
delinquent? No one knew there were any problems with them? Is 
that fair to say?
    Mr. Killinger. I believe--yes. Clearly, our policy and what 
I believe is that at the time when certain loans were sold--all 
of our loans were sold--that we felt that would be appropriate 
for the customer. We had put out responsible lending 
principles, in fact, that require us to make that proactive 
look. Is this an appropriate product for the customer, and 
given the times, do we think it is reasonable? That changed 
when the housing market changed. That is why we pulled back and 
stopped originating Option ARMs and did the same on certain 
subprime products, because given what happened to the housing 
market, those products were no longer appropriate. But at the 
times when they were part of our arsenal, we thought that they 
would be appropriate.
    Senator Kaufman. What do you think, Mr. Rotella? Is the 
vast majority of products you were selling through mortgage-
backed securities were safe for customers? There wasn't any 
fraud involved. There were no loans ready to be delinquent, 
anything like that that you know of?
    Mr. Rotella. Senator, the company again was a massive 
mortgage lender.
    Senator Kaufman. Sure.
    Mr. Rotella. As I said earlier, prior to my arrival it was 
No. 2 in the industry, and it peaked at about $420 billion in 
originations in 2003. So the amount of product either put into 
portfolio or sold was significant. So in any business doing 
that amount of volume over a number of years, particularly 
given some of the weaknesses in the operating infrastructure, 
you are going to have loans that will get into the 
securitization process that probably should not have.
    Our policies, my policies when I was at JP Morgan Chase for 
18 years and CEO of their mortgage company, you would not do 
that. And if you knew about it, you would stop it, and----
    Senator Kaufman. You must have been alarmed when you read 
about these Long Beach memos and the things that Chairman Levin 
is talking about where people were cutting and pasting and 
things like that were going on at a time when it was pretty 
clear that the explosion--not only the new explosion in new 
houses being sold, but the explosion of mortgage-backed 
securities, this great sucking sound as we brought all these 
things into it, you had to be concerned that people were 
beginning to bend the rules, especially with the compensation. 
I mean, you are a smart man. As you said, you have loads of 
experience in this business. You just look at these things, and 
you say this business is so big, I do not know what is going 
on. This is a business that is exploding. It is exploding in a 
very competitive time. People's compensation was based on doing 
well, and doing well meant selling as many risky things as you 
could.
    I mean, you had to at least have a feeling that there was 
something going on here that was a little scary.
    Mr. Rotella. Senator, Chairman Levin repeated a couple of 
colorful comments I made in some emails about my views of the 
business. As I said in my opening statement, this business was 
on an explosive growth path when I joined. It was on an 
explosive growth path with a very weak infrastructure.
    Senator Kaufman. Exactly.
    Mr. Rotella. I was brought in there to fix that, and I 
worked night and day to do that, brought in the people to do 
that, and we made a lot of strides.
    Senator Kaufman. Yes.
    Mr. Rotella. We also brought that business down 
significantly. So if I was not concerned, I would not have 
taken some of the actions I did to bring in new management, to 
bring in new technology, to restructure the business, and to 
take volume down, and ultimately shut down the subprime 
business totally, as well as Option ARMs.
    Senator Kaufman. And also shut down Long Beach, right?
    Mr. Rotella. I did recommend the shutting down of Long 
Beach.
    Senator Kaufman. Good. Let me ask you, Mr. Killinger, just 
a final question I have. With all that going on, you get a 
report from Mr. Vanasek and Mr. Cathcart; they are worried 
about an impending crisis due to lax standards and poor 
internal controls as early as 2004. When they came and talked 
about that, didn't it kind of send chills--I mean, you made 
Washington Mutual what it is today. The idea that your two risk 
officers one right after another coming in in 2004 and saying, 
we have got a real big problem here--kind of go through what 
went through your head between 2004 and 2005 and 2006.
    Mr. Killinger. This is relating to the subprime business?
    Senator Kaufman. Yes, the whole thing that they were just 
concerned about lax standards, poor reports from Long Beach, 
all the things that were coming into your office--you are the 
CEO--and your two top risk guys are saying we have a real 
serious problem here. And, obviously, you hired Mr. Rotella 
because you were concerned about this.
    Mr. Killinger. Absolutely. So, again, let me put it very 
quickly into perspective.
    First, Long Beach mortgage was a very small part of our 
operation, maybe 3 percent of our employees, and it was just a 
small part of what we were doing. So when reports arose that 
there were some problems there, the first time I actually 
instructed our general counsel to go in and work on getting 
things cleaned up in terms of the represenatives and warranties 
and getting it straightened up, and they thought they were 
making some progress.
    Then I had a brief period where it looked like things were 
going along OK. Then we started to get some reports about that 
we are seeing some more problems. So we decided to change out 
management, saying, go ahead, I want a new opportunity to get 
in here. And it was also obvious, again, overall that the 
company had expanded to a size that it was appropriate--in 
2004, we made a decision to bring in a president and chief 
operating officer to be able to be hands-on and be on top of 
these things because, frankly more and more of my time was 
being pulled away from all the things and travel you have to do 
as a CEO. And we thought that would be a very good structure. 
And I think that was the right thing to do, and I think that it 
was not only bringing Mr. Rotella in. He in turn brought in a 
lot of talent in the mortgage space where we needed the most 
talent, including--you saw David Schneider and David Beck, and 
just a whole host of other people that came in behind it.
    So our response to these ongoing problems was to try to fix 
it, change out management, try to work as hard as we could, but 
then also understanding that the market was getting 
progressively more difficult, and that kind of tipped us at one 
point of saying, I think we are making some progress here, but 
the market has gotten tough enough, let us just plain close 
that business down.
    Senator Kaufman. Thank you.
    Senator Levin. Thank you, Senator. Dr. Coburn.
    Senator Coburn. Mr. Killinger, I want to refer you to 
Exhibit 39,\1\ where, on April 3, 2007, you said, ``I think we 
better be well prepared to defend the Option ARM portfolio.'' 
If you will go to Exhibit 39, that is in a statement that you 
made.
---------------------------------------------------------------------------
    \1\ See Exhibit 39, which appears in the Appendix on page 628.
---------------------------------------------------------------------------
    Mr. Killinger. OK. Yes.
    Senator Coburn. What I would like to know, did you believe 
at that time that Option ARMs were likely to cause widespread 
problems and this would force WaMu to defend its actions?
    Mr. Killinger. No.
    Senator Coburn. What was the basis for that statement?
    Mr. Killinger. The statement was I was passing on to some 
executives a letter that I received from somebody outside of 
the organization who had an opinion about Option ARMs, and part 
of why I was passing it on is to the folks to think through 
both what does this mean in terms of what investor interest 
might be and how we might need to explain about Option ARMs to 
the investors in our company, and also to take a look, again, 
if market conditions are changing and, if they are, is there 
anything else that we should consider doing in our Option ARM 
portfolio.
    Senator Coburn. Exhibit 11,\2\ you said, in April 2006, 
``We may want to continue to sell most of the Long Beach 
originations until everyone gets comfortable with credit.'' Why 
do you think anyone would have wanted to buy what you were 
selling if the Long Beach product was bad?
---------------------------------------------------------------------------
    \2\ See Exhibit 11, which appears in the Appendix on page 414.
---------------------------------------------------------------------------
    Mr. Killinger. Well, again, Long Beach's business model was 
to originate and sell its products ever since we bought them, 
so that was their sole business model, was to originate and 
either sell its loans or into securitizations. We were in the 
process of changing that business to move it under the bank so 
that we had more flexibility to potentially retain some of the 
loans that we would originate, and we just started to do some 
of that process. But I wanted to be assured that before we 
expanded our volumes and took more into portfolio and changed 
what we were doing, that we felt very comfortable about credit, 
processes, and all those kinds of things.
    Senator Coburn. In Exhibit 50,\1\ Mr. Beck said to you, in 
November 2006, that Long Beach Mortgage Computer paper is 
``among the worst performing paper in the market in 2006.'' Did 
you see in April what Mr. Beck found to be true in November, 
namely, that LBMC paper was going to tank?
---------------------------------------------------------------------------
    \1\ See Exhibit 50, which appears in the Appendix on page 670.
---------------------------------------------------------------------------
    Mr. Killinger. No, I do not recall this.
    Senator Coburn. So you were not aware of his statement that 
it was the worst in the market?
    Mr. Killinger. I do not see what you are referring to----
    Senator Coburn. Mr. Beck said in Exhibit 50, in November 
2006, that Long Beach Mortgage Corporation paper is among the 
worst performing paper in the market.
    Mr. Killinger. OK. I just do not recall seeing this memo.
    Senator Coburn. Who is the memo addressed to in front of 
you?
    Mr. Killinger. The one I am seeing is David Schneider and 
Arlene Hyde.
    Senator Coburn. So you were unaware of their assessment of 
your paper.
    Mr. Killinger. Again, I just do not recall the specifics of 
this at all.
    Senator Coburn. OK. Exhibit 78a,\2\ in this email exchange 
from March 10, 2005, with Jim Vanasek, you wrote, ``I 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 decline. This typically signifies a 
bubble.''
---------------------------------------------------------------------------
    \2\ See Exhibit 78a, which appears in the Appendix on page 790.
---------------------------------------------------------------------------
    Is it accurate to say that you saw a bubble in housing 
prices as early as March 2005?
    Mr. Killinger. Yes.
    Senator Coburn. Did you see a bubble in housing prices 
before March 2005?
    Mr. Killinger. I do not recall my exact timing. I do 
remember making public comments beginning in the middle part of 
2005. I remember talking to the board from time to time about 
that there was growing risk because housing prices are growing 
faster than the rate of inflation. But also at the same time, I 
can remember everybody arguing of why that is going to be OK 
and it is unlikely to be a significant downturn in housing.
    We were kind of the front edge of trying to assess that 
there was a concern here.
    Senator Coburn. Well, that follows into my second question 
because in January 2005 is when you pushed forward a high-risk 
lending strategy for board approval. Only 2 months earlier, if 
you saw that prices would decline in the near future, why would 
you be pushing through a high-risk strategy on a market that 
you thought was a bubble?
    Mr. Killinger. Well, Senator, we approved a new strategic 
plan in actually that summer of 2004, and this is not the whole 
plan. Remember, this is a small part of our business. But part 
of that plan was increasing the subprime portfolio that we had 
in our portfolio over a period of time. But I also was very 
careful to say that is going to be subject to market conditions 
and we will be opportunistic. And the reality is we did not 
execute on that. We ended up shrinking that portfolio that we 
held, rather than growing it.
    Senator Coburn. Yes, and this chart actually shows that.
    Mr. Killinger. No. What shows is what we held in portfolio, 
and the facts----
    Senator Coburn. The loan originations also show it.
    Mr. Killinger. Yes, our originations declined and our 
market share of subprime originations declined from--first of 
all, we were only 6 percent, and we cut it to about 3 percent, 
and that market share was about half of what we had in the 
overall market. But in terms of what we held in portfolio, the 
portfolio shrank, and we had plans to grow it.
    Senator Coburn. Between 2004 and 2005, at the time you 
shifted towards this high-risk strategy, at the same time you 
switched from doing business with Fannie Mae to doing more 
business with Freddie Mac. Is that simply a coincidence? Or was 
there a business advantage to moving to Freddie Mac from Fannie 
Mae?
    Mr. Killinger. I do not have the personal details of the 
pros and cons of doing business with each of them. Those 
contracts were negotiated actually in the Home Loans group, and 
I think Mr. Rotella might have been involved there. So I cannot 
recall why one was picked over the other, but we always tried 
to have them in a good competitive position.
    Senator Coburn. I would like to enter into the record the 
Washington Mutual document Fannie Mae alliance and Freddie Mac 
business relationship proposal from May 2005.\1\ Here is what 
your executive summary says. The key to the Freddie proposal is 
it provides significant liquidity for our Option ARM 
originations with more advantageous credit parameters, 
competitive G-fees and preferred access to the balance sheet 
relative to our current agreement with Fannie. So it was an 
economically driven position.
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    \1\ See Exhibit 90, which appears in the Appendix on page 920.
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    Mr. Killinger. Yes, that sounds like a better deal, and not 
just Option ARMs, but I think I also heard better guarantee 
fees in that explanation.
    Senator Coburn. All right. I have one final question for 
you, Mr. Killinger. At one time towards the end, before the 
FDIC came in on your business, were you in negotiations to sell 
this business?
    Mr. Killinger. In the spring of 2008, we determined that 
the housing market was continuing to soften and that we needed 
to either raise new capital or seek a merger partner. And the 
board went through a very thorough review of alternatives at 
that time, and we considered both the potential sale, then we 
looked at the equity infusion that we could get, and we 
ultimately made a decision to take in $7.2 billion in an equity 
infusion. And that is what the board elected to do.
    Senator Coburn. And how were you going to do that?
    Mr. Killinger. We did it. How?
    Senator Coburn. So how did you accomplish that $7.2 billion 
equity infusion?
    Mr. Killinger. It was a combination, as I recall, of a 
convertible preferred that basically most of it would convert 
into a common once we got the additional shares approved by 
shareholders, and there were certain warrants attached to that, 
and it was led by a private equity--a number of large 
institutional investors.
    Senator Coburn. So you actually sold that equity and those 
warrants and that convertible preferred?
    Mr. Killinger. There was a private placement offering of 
those.
    Senator Coburn. But it was sold.
    Mr. Killinger. Yes.
    Senator Coburn. And who represented the other side of that 
transaction? Who was the broker-dealer or the underwriter? Who 
was the lead placement firm?
    Mr. Killinger. The lead placement for us would have been 
Goldman Sachs and Lehman Brothers, I believe.
    Senator Coburn. OK. All right.
    Mr. Rotella, under Exhibit 2a,\1\ and in your testimony \2\ 
you mentioned that Washington Mutual had adopted the high-risk 
lending strategy before you arrived. That is on page 4 of 
Exhibit 2. You said, ``I did not design this strategy'' on page 
5 of your testimony. Did you mean to imply some distance 
between yourself and this strategy?
---------------------------------------------------------------------------
    \1\ See Exhibit 2a, which appears in the Appendix on page 229.
    \2\ See Mr. Rotella's prepared statement which appears in the 
Appendix on pge 169.
---------------------------------------------------------------------------
    Mr. Rotella. Senator, as I said in my opening statement, 
shortly after arriving at Washington Mutual and having been an 
observer from JP Morgan Chase, I was aware of the fact that the 
company had an extreme concentration in real estate loans as a 
thrift. It had a concentration in Florida and in California, 60 
percent of its mortgage assets. As I said earlier, it was going 
through explosive growth, particularly in higher-risk lending, 
and the operating infrastructure was quite weak. That combined 
with the view that the housing market was softening led a group 
of us to begin a process of diversifying the company and de-
emphasizing the mortgage business, which over time we hoped 
would lead us to a company that was concentrated less in real 
estate and had other asset classes.
    Senator Coburn. So in your testimony, on the one hand you 
say that you were simply carrying out the chairman and CEO's 
strategies as far as the high-risk category; but on the other 
hand, you are saying it was your decision to decrease the high-
risk lending. Which is it?
    Mr. Rotella. Senator, no, I am not saying it was my 
decision, but I and others believed that the company needed to 
diversify itself and move away from its mortgage legacy. That 
was a discussion amongst a number of executives and ultimately 
up to the CEO, and we made a firm decision to take some of the 
proactive steps that I have mentioned in the mortgage business 
and also begin to diversify some of our other businesses.
    Senator Coburn. What was going on at Long Beach other than 
what we have discussed here today that required the whole 
management structure to be changed, in your view?
    Mr. Rotella. When I joined WaMu in 2005, a big 
organization, I moved from the east coast to the west coast and 
was getting familiar with the company, my first focus was in 
the main home loans business, which did not have a leader at 
the time. It was reporting up to the same person who was 
running both our commercial mortgage and our subprime business. 
I took that business over and ran it myself until I hired 
somebody, and as I instituted a series of business reviews in 
the company, I became increasingly concerned at a couple of 
things in Long Beach. One, the growth path was just incredibly 
rapid, and, two, I could not get transparency into what was 
happening in the business, which always worries an executive.
    Over the course of that second half of the year, I became 
increasingly concerned, and ultimately towards the end of the 
year, there was this fairly significant repurchase blow-up that 
has been discussed earlier in the day. I made a recommendation 
at that point to move forward on making management changes 
based on the combination of those factors.
    Senator Coburn. All right. One last question, if I could. 
How dependent, in your view, was Washington Mutual on its 
relationship with Fannie Mae and Freddie Mac?
    Mr. Rotella. Well, like all big mortgage lenders, Senator, 
Fannie Mae and Freddie Mac were important, and I would not call 
it dependent, but there was a substantial amount of production 
that was sold off to either Fannie or Freddie. After I got 
there, it was switched over to Freddie Mac. So depending on 
what level of dependency you would like to characterize it as, 
any 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.
    Senator Coburn. All right. Thank you.
    Mr. Killinger, one last question. At any time prior to the 
closure by the FDIC, did you have conversations with a major 
financial firm in New York about the sale of your business to 
them?
    Mr. Killinger. As I commented previously----
    Senator Coburn. I am asking the question again specifically 
to give you a chance to answer that question. Did you have 
conversations with principals of financial firms in New York 
City about the sale of WaMu or the capture of WaMu by a larger 
financial institution?
    Mr. Killinger. Yes, and as I said earlier, that was in the 
spring, in that March-April period when the board considered 
all strategic alternatives between raising capital as well as--
--
    Senator Coburn. And that was Goldman Sachs and Lehman?
    Mr. Killinger. They were the investment bankers working 
with us.
    Senator Coburn. Were there others that you had 
conversations with?
    Mr. Killinger. Well, they were representing us.
    Senator Coburn. Who did they have conversations with in 
terms of the sale of the business, not raising additional 
capital but the sale of the business?
    Mr. Killinger. There were, I will say, a handful of 
potential interested parties. We put out a net that was broad, 
both domestically and internationally, to see if anyone would 
be a potential partner at that time, and the investment bankers 
talked to a number of them, and then there were a couple of 
parties that we talked on a more private basis.
    Senator Coburn. Would you be so kind as to give the 
Subcommittee the names of those individuals?
    Mr. Killinger. I am not sure that has been publicly 
disclosed. I am not sure what my rights are.
    Senator Coburn. Well, your company is gone, and for us to 
get to the bottom of this, we need to know every detail. So you 
can refuse to answer, and then we will work on that. But the 
fact is that information is going to come out, and good lawyers 
do not ask questions they do not already know the answers to. 
So I think it would probably be beneficial--and I am not a 
lawyer, by the way--for you to give us that information. You do 
not have to do it publicly, but you can give it to the 
Subcommittee.
    Mr. Killinger. OK.It is Exhibit 89.\1\
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    \1\ Exhibit 89 is a Sealed Exhibit and is retained in the files of 
the Subcommittee.
---------------------------------------------------------------------------
    Senator Coburn. All right. Thank you, Mr. Chairman.
    Senator Levin. Thank you very much, Senator Coburn.
    Let me go back to your strategy. You say you adopted this 
shift to high-risk strategy in 2004 and 2005. Is that correct? 
But that it was not implemented, you did not execute it.
    Mr. Killinger. Not all elements.
    Senator Levin. Well, you surely executed your focus on 
high-risk products. Take a look at Exhibit 6b.\2\ Take a look 
at that exhibit, called ``Home Loans--2007 Strategy Team Goals, 
Updated 11/12/07.'' Your goal is ``GROWTH, 45%; Drive Nonprime 
expansion initiative . . . Support market share Increases for 
nonprime product.'' Key to success: ``Focus by all channels on 
targeting higher-margin products.'' That is higher-risk 
products.
---------------------------------------------------------------------------
    \2\ See Exhibit 6b, which appears in the Appendix on page 342
---------------------------------------------------------------------------
    Mr. Killinger. OK. I am sorry. I am behind Tab 6.
    Senator Levin. You sure tried to execute that new strategy 
for at least a year, year and a half.
    Mr. Killinger. And, Senator, we did execute elements of it.
    Senator Levin. Well, let us just focus here on higher-
margin products. You want to focus all channels on targeting 
higher-margin products, drive non-prime expansion initiative. 
That is your goal.
    Mr. Killinger. I am trying to catch up here.
    Senator Levin. Updated 11/12/07, by the way. Do you see 
that, ``Updated 11/12/07''?
    Mr. Killinger. OK. I am seeing this, yes. OK. So this is 
the target for the Home Loans group that we are looking at, not 
the company.
    Senator Levin. Right. Drive non-prime expansion.
    Mr. Killinger. Yes.
    Senator Levin. OK.
    Mr. Killinger. If I could, again--because I am setting 
the--with the board setting the strategy for the overall 
company, it really needs to be in the context, when we talked 
about diversifying the company, that included having a strategy 
for entering the credit card business, and we subsequently did 
the Providian acquisition, which was a significant part.
    It also had a material reduction in interest rate risk. 
That is why we sold so many mortgage servicing rights. And we 
also had, even in the Home Loans area, that this would be a 
lesser part of our overall business, and that the primary 
growth of the business would be in our retail banking stores, 
and that is where we are going to open up significant numbers 
of retail banking stores.
    So the overall context of the company is still a shrinkage 
of the home lending business, but within the home lending 
business that we would have more of a focus on some of these 
other products.
    Senator Levin. Some of the other products being high-risk 
products.
    Mr. Killinger. Like subprime, but which we did not execute 
on.
    Senator Levin. Well, you executed on a bunch of high-risk 
products. You have Option ARMs, subprime, home equity. You 
executed on them.
    Mr. Killinger. We did execute on expanding our portfolio in 
home equity. We did not expand the portfolio of Option ARMs. 
Option ARMs actually declined in the size of those portfolios.
    Senator Levin. It was still larger than it was in 2003, so 
you had a significant amount of Option ARMs even as late as 
2006. But this is a 2007 document talking about channeling--
focus ``all channels on targeting higher-margin products.'' 
Those are higher-risk products. That is November 2007.
    Here is what you said, June 6, 2006, in your report:\1\ 
``Finally, our Home Loans group should complete its 
repositioning''--that is the repositioning that you had decided 
on in 2004 and 2005, to focus more on high risk. June 6, 2006, 
``Our Home Loan group should complete its repositioning within 
the next 12 months''--so that is June 2006 to June 2007--``and 
will be in a position to profitably grow its market share of 
Option ARM, home equity, subprime, and Alt A loans.''
---------------------------------------------------------------------------
    \1\ See Exhibit 6d, which appears in the Appendix on page 357.
---------------------------------------------------------------------------
    Mr. Killinger. That was the plan. We just did not execute 
it because of changing market conditions.
    Senator Levin. I know, but on June 6, 2006, you are still 
planning on executing it. This was a plan that you shifted to 
in 2004 and 2005. So you did execute this for about a year, a 
year and a half.
    Mr. Killinger. We started down that direction, but much 
less than what we had planned, and as housing became more 
challenging, we moved even further away from that plan.
    Senator Levin. I understand, but I do not think you ought 
to get away with the statement you did not execute it. You did 
execute on it for about a year, a year and a half. You tried to 
execute it until the market changed.
    Mr. Killinger. OK.
    Senator Levin. Now, here is a pie chart we have here which 
shows the percentage of your inventory which is high risk 
compared to the low risk.\1\ Just take a look at 2003 in blue. 
In blue, the majority low-risk, 30-year loans, fixed loans. 
2004, look at the dramatic shift. The red is your high risk, 
and as a part of your inventory, starting in 2004 going through 
2005, 2006, 2007, the blue, which is your traditional 30-year, 
typically fixed loans, become no more than a quarter of your 
inventory. The high-risk part of the inventory goes from about 
a third in 2003 to three-quarters in 2007. So you may have 
shrunk your total inventory, but as a percentage of your 
inventory, you are still focused on high-risk products. Is that 
accurate?
---------------------------------------------------------------------------
    \1\ See Exhibit 1i, which appears in the Appendix on page 223.
---------------------------------------------------------------------------
    Mr. Killinger. No, sir.
    Senator Levin. OK. Then tell me where that is wrong.
    Mr. Killinger. But this is a chart not of inventory, it is 
a chart of mortgage origination.
    Senator Levin. I should have said that. Is that accurate in 
terms of your originations and your purchases by percentage?
    Mr. Killinger. I believe it is.
    Senator Levin. OK. That is fine. I stand corrected. In 
terms of originations and your purchases by percentage, two-
thirds low-risk, fixed mortgages in 2003. Starting in 2004, 
2005, 2006, 2007, it become less than a quarter by 2007. And 
that is the point. You changed your strategy. You shrunk the 
whole pie. That is true. But you also started to implement your 
high-risk strategy, and that is clear from your own words which 
I just read, and when the strategy became frustrated because of 
the market, you then shrunk the whole pie. But you did not 
shrink the percentage of your originations and purchases that 
went to the high-risk products.
    Mr. Killinger. And, Senator, the one point I want to be 
crystal clear on is that 2002 and 2003 were very unusual years 
for fixed-rate products because the country was going through a 
massive refinancing boom, and that is where so much of the 
origination was. If I went back to a more normalized time, like 
2 years before that, you would have seen a balance that was 
more reflective of 2004 and 2005 and 2006 than it was of 2003. 
It is the only point I wanted to make there.
    Senator Levin. June 12, 2006, I am going to read this 
again: ``Finally, our Home Loans group should complete its 
repositioning within the next 12 months''--that is your 
strategy, June 2006--``and will be in a position to profitably 
grow its market share of ''--you are trying to grow your market 
share of high risk in June 2006. That is your plan. Option ARM, 
home equity, subprime, Alt A loans, that is your plan, right, 
in June 2006. I know that it changed after that, but that was 
still your strategy. I am just reading your words.
    Mr. Killinger. We had the plans----
    Senator Levin. In June 2006, you still had the plan.
    Mr. Killinger. If market conditions were satisfactory and 
we could execute profitably on that----
    Senator Levin. That is always true about market conditions, 
but your plan was, ``Our Home Loans group should complete its 
repositioning within the next 12 months and will be in a 
position to profitably grow its market share of Option ARM, 
home equity, subprime, and Alt A.'' Those are the high-risk 
loans. I am just reading your own words.
    Now, let us turn to Exhibit 34,\1\ which is an internal 
WaMu review by its Risk Mitigation and Mortgage Fraud Group. 
This is September 8, 2008. You are right here on the brink of 
going out of business, but that is not the point here that I am 
trying to read.
---------------------------------------------------------------------------
    \1\ See Exhibit 34, which appears in the Appendix on page 564.
---------------------------------------------------------------------------
    Take a look at the first finding. This is September 8, 
2008. This is, I think, a couple weeks before you were taken 
over. The first finding of the review, page 3. I want to get 
back to all the fraud here, because it is one thing to say that 
you could not know with certainty that there was a housing 
bubble that was going to burst, even though you predicted it. 
The issue is not that you did not know when the housing bubble 
would burst. The problem is what did you know about what was 
going on in your own company in terms of how much fraud was 
going on. That becomes the issue that I want to focus on, the 
level of fraud and what you knew or did not know about that.
    Here is what you were told in 2008. This is September 8, 
2008. ``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.'' Now, 
that should have set off some alarm bells. Your fraud controls 
and misrepresentation controls are not effective. And it says, 
``There is not a systemic process to prevent a loan in the Risk 
Mitigation Inventory and/or confirmed to contain suspicious 
activity from being sold to an investor.''
    And then there is a test of 25 loans; 11 reflect a sale 
date after the completion of the investigation which confirmed 
fraud. That is going on inside your company. You cannot predict 
with certainty the bubble. But this is what is happening inside 
your company when you got that report.
    Maybe I should ask Mr. Rotella as well. You got this 
report. What was your reaction?
    Mr. Rotella. Senator, any instance of fraud that I became--
--
    Senator Levin. I know, but what was your reaction to this 
document? I know any instance of fraud--I got that. That is the 
way people should react. But now you have a document saying not 
any instance. Look, this is what happened. You do not have any 
controls for fraud and it is going on.
    Mr. Rotella. Senator, there were instances of fraud I was 
aware of over the 3\1/2\ years I was at WaMu, and as I said, I 
authorized----
    Senator Levin. No, I mean controls.
    Mr. Rotella. Budgets, people, expenses to put in fraud 
monitoring tools.
    Senator Levin. Not effective. That is what you were told.
    Mr. Rotella. Clearly, this report indicates that in 
September 2008, about 3 weeks before the seizure of the 
institution.
    Senator Levin. It says something else. It says that there 
is ``evidence that this control weakness has existed for some 
time.'' A lack of controls for fraud, according to this 
report--this is your own internal report--has existed for some 
time. What was your reaction when you read that?
    Mr. Rotella. I don't recollect exactly what my reaction 
was, but I can tell you that, reading this now, I have the same 
reaction I probably had then. I would not be happy with it and 
I would authorize people to fix it.
    Senator Levin. Mr. Killinger, what was your reaction?
    Mr. Killinger. I wasn't at the company at this time.
    Senator Levin. You had already gone. Well, now that you 
read it, what is your reaction? For some time, controls for 
fraud in your company were not effective. What is your reaction 
when you see it now?
    Mr. Killinger. Exactly what I just heard from Mr. Rotella. 
You read this. It is very serious and you say, get on it. Where 
are the resources? And get it fixed.
    Senator Levin. Now, during a prior panel, we discussed the 
number of emails that show that a decision was made in early 
2007 to sell Option ARMs that would normally go into the 
investment portfolio. And the reason that decision was made is 
because similar Option ARM loans from the fourth quarter of 
2006 were already showing serious delinquencies. It was 
authorized that $3 billion in Option ARMs would be sold on an 
urgent basis. You were here, were you, both of you, when I went 
through those documents?
    They were already in the hold-for-investment portfolio, and 
they were reclassified on an urgent basis for sale, clearly 
because there was an assessment made in those emails it is 
clear these were likely to be delinquent and damn soon. We had 
better get rid of these damn soon. There is a great risk of 
default.
    Now, when you look at Exhibit 40b,\1\ if you would, on page 
2, one of these emails is February 18, 2007, by Cheryl Feltgen, 
the Chief Risk Officer for your Home Loans Division. Here is 
what she wrote: ``There is a meltdown in the subprime market 
which is creating a flight to quality. I was talking to Robert 
Williams just after his 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 [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?''
---------------------------------------------------------------------------
    \1\ See Exhibit 40b, which appears in the Appendix on page 632.
---------------------------------------------------------------------------
    Now, I believe, Mr. Killinger, since you are referred to, 
that you remember that?
    Mr. Killinger. I remember that period of time and being at 
this, we call it MBR or Monthly Business Review, and----
    Senator Levin. Do you remember saying that we should think 
seriously about getting rid of these Option ARMs?
    Mr. Killinger. Not about these Option ARMs. What I do 
remember is going through a discussion about the benefits of 
doing share repurchase versus growing our balance sheet.
    Senator Levin. Do you remember a discussion about 
delinquencies and that being a reason why you had better get 
rid of Option ARMs quickly, because they are likely to become 
delinquent? Do you remember those conversations?
    Mr. Killinger. I don't recall the specifics, that the 
reason was around delinquencies or around attractive pricing, 
that others were buying assets at very good prices and we would 
be better off to redeploy our capital in some other way.
    Senator Levin. She says you talked about this subject and 
that delinquencies were--these emails were full of that 
subject. What you are saying is delinquencies may have been 
part of the conversation?
    Mr. Killinger. I just don't recall because I haven't seen 
other documentation and I wasn't, I don't think, directly 
included on these.
    Senator Levin. All right. Did you know that during the 
first quarter of 2007, that WaMu was securitizing Option ARM 
loans because of their greater likelihood to fail? Did you know 
that?
    Mr. Killinger. I don't have a recollection of that.
    Senator Levin. What did you think when you heard these 
emails today? Did that surprise you? Did that trouble you, that 
suddenly delinquencies hit very hard, and now you have got your 
staff that is saying, we had better get rid of these quick. Did 
that trouble you when you heard it today?
    Mr. Killinger. Well, I don't recall having seen something 
like that before, so it was--it is just something that was new 
to me----
    Senator Levin. And when you heard it today, when it was new 
to you, what was your reaction?
    Mr. Killinger. Well, my reaction on the plus side was that 
if they were talking about----
    Senator Levin. No, just what I read, delinquencies, 
delinquencies, delinquencies, urgent, urgent, urgent, midnight 
emails. We have got to move quickly on this. When you heard 
that, what was your reaction to it?
    Mr. Killinger. Well, when I heard about the urgency, it was 
more around that they need to be in a very timely way to do a 
transaction. I didn't get it about that it was because there is 
going to be an urgent change in loan performance or something. 
But when we decide to go sell or buy an asset, I know these 
people have to move fairly quickly to identify what they want 
to sell and buy, and there is also a factor of the geographic 
concentration, because we had--it is difficult for us because 
we kept trying to find ways to reduce our concentration in 
California because we had a natural propensity to originate so 
many loans there.
    Senator Levin. Mr. Killinger, that is maybe what you would 
have liked to have heard, but I am asking you what you heard 
today.
    Mr. Killinger. Yes.
    Senator Levin. What you heard today was these loans are 
delinquent. We are having a heavy flood of delinquent loans in 
the fourth quarter. And then the criteria for those loans were 
laid out. And then there was a decision made urgently. We have 
got to sell these loans. We can still sell them. It was 
significantly based on delinquencies. It was the subject of 
every single email.
    Now, when I read that, you may have wanted to hear that you 
wanted to sell them in order to gain capital, but what I read 
to you was that there was a high rate of delinquencies and we 
have got to move quickly. And my question to you is, when you 
heard that--not what you wanted to hear, what you did hear, I 
hope, and I read them and I am not going to go through them 
again unless you want me to--did that trouble you? Would 
selling those mortgages for that reason trouble you without 
disclosing that to investors? Would that trouble you?
    Mr. Killinger. It would trouble me certainly if it didn't 
have the proper disclosures which we had.
    Senator Levin. OK----
    Mr. Killinger. I do want to make one point, to be very 
careful in here. I don't know if it relates here, but we had a 
regular program of selling non-performing assets. It was part 
of our risk mitigation program, where we would take problem 
assets, pool them up, sell them off to investors that were 
interested in buying those.
    Senator Levin. Right, but that is not what I am talking 
about. I am talking about here you had a significant flood of 
delinquencies in that fourth quarter. You were continuing to 
originate or to buy these Option ARMs. You had a study made. 
That study showed that certain specified criteria were the key 
factors in those delinquencies. A decision was made, you had 
better dispose of Option ARMs clearly following that 
assessment. You made an assessment. Was that assessment 
disclosed to investors?
    Mr. Killinger. I have no idea.
    Senator Levin. Should it have been?
    Mr. Killinger. Well, it would seem that would be--
certainly, any security sale that we have should have all the 
appropriate disclosures.
    Senator Levin. Would that be appropriate to disclose that 
assessment which you made internally relative to the likely 
delinquency of those mortgages?
    Mr. Killinger. Well, again, I have----
    Senator Levin. Is that not relevant to a buyer?
    Mr. Killinger. Again, I don't know what the actual sales 
were and I don't know what the actual disclosures or anything 
about that. So it is very difficult for me to talk in a 
hypothetical.
    Senator Levin. You should have been disturbed by what you 
heard here today, OK? It is very clear, you should have been 
disturbed by that. I would hope that you would have said, yes, 
if I had known that, I would have been disturbed. That is what 
I hoped you would have said. Instead, you want to wrap it in 
hypotheticals and say, well, it is hypothetical. It is not 
hypothetical. These are emails, one after another, delinquency, 
delinquency, delinquency, we have got to move, we have got to 
move, urgent, midnight emails, we have got to move. I talked to 
Killinger. He says we have got to move. And now you are saying, 
well, what, sometimes we sell assets? We are talking about 
these emails, Mr. Killinger.
    Mr. Killinger. What I also heard this morning was that Mr. 
Beck didn't know if we actually sold these or if we sold--what 
happened in the transaction, so I am kind of dealing with the 
transaction. I just don't know what actually happened.
    Senator Levin. Should you have known? Were you aware that--
--
    Mr. Killinger. No, I wasn't aware of specifics on that. 
These are not the kind of size and transactions that I would 
normally get involved in.
    Senator Levin. You don't get involved in $3 billion 
authorizations?
    Mr. Killinger. No. Those would be handled within the group.
    Senator Levin. Three billion?
    Mr. Killinger. Yes, out of a $300 billion----
    Senator Levin. Yes, but $3 billion being sold on an urgent 
basis, we are going to get--we need $3 billion. We have to do 
it this quarter. In fact, the loans that we are originating 
right now, we are going to sell immediately. That is how urgent 
it was to move on this.
    Mr. Killinger, you are under oath here. It seems to me if 
you are not disturbed by this, you should be, and it is hard 
for me, frankly, to accept that you would not be troubled if 
you had read then what you heard this morning. And you are 
saying that if you had read all those emails back then, you 
would not have been concerned. Is that what you are saying?
    Mr. Killinger. I am saying I would be concerned if there 
was anything that was done inappropriate on disclosure, which I 
don't know.
    Senator Levin. No. I am talking about those emails. Would 
you have been concerned then if you had read those emails? 
Would you have inquired, are we selling these things? Are they 
part of the $3 billion? Would you have made that inquiry or 
thought it ought to be made? Are we disclosing this to 
investors? Would you have thought--we have made a study of 
this. We have looked at the reason for these delinquencies. We 
have a guy who says there are eight reasons. Here they are. 
They are laid out. Then you have emails that are saying--and 
these were late in the evening, early morning emails, urgent, 
urgent, urgent, delinquency. Would that have troubled you if 
you had seen those emails then?
    Mr. Killinger. Again, I did not see the emails and I don't 
know what ended up happening on this----
    Senator Levin. Not ended up. I am saying, before. I am just 
saying the emails. This is before they were securitized. The 
decision was made to put up to $3 billion of those mortgages 
into securities. Before a decision was picking which ones to 
put in the securities, would you have been troubled by those 
emails? That is my question.
    Mr. Killinger. Well, I am troubled that it was just on the 
basis of performance.
    Senator Levin. Just what you heard today, just those 
emails. That is all I am asking you. If you had seen those 
emails--you have heard them. I have read them. I will read them 
again to you. Would you have been troubled if you had read 
those emails then?
    Mr. Killinger. I would have inquired more. I wanted more 
information.
    Senator Levin. OK.
    Mr. Killinger. That is what I want.
    Senator Levin. OK. Well, I guess that is progress.
    Take a look, if you would, at Exhibit 69a.\1\ This is an 
email from you, Mr. Killinger, dated October 12, 2007. This is 
responding to a colleague's email discussing the hiring of 
Goldman Sachs or another investment bank to help WaMu consider 
ways to reduce its credit risk or raise new capital. Your 
senior staffer wrote, ``we always need to worry a little about 
Goldman because we need them more than they need us and the 
firm is run by traders,'' presumably meaning they act in their 
own self-interest and not on behalf of their clients.
---------------------------------------------------------------------------
    \1\ See Exhibit 69a, which appears in the Appendix on page 759.
---------------------------------------------------------------------------
    And here is your response. ``I don't trust Goldy on this. 
They are smart, but this is swimming with the sharks. They were 
shorting mortgages big time while they were giving CFC 
advice,'' CFC being Countrywide Financial Corporation.
    Now, what led you to say that Goldman Sachs was shorting 
mortgages big time while giving advice to Countrywide?
    Mr. Killinger. Well, I think this was, again, just a brief 
comment. I don't recall having any specific knowledge, but I 
probably read about that or might have heard in general about 
what they were doing at that same time, and I was just trying 
to make a point, probably in a little flippant way, that if we 
are going to engage an investment bank through here to help us 
on any of these transactions, we need to understand that they 
may have a conflict of interest.
    Senator Levin. Was that a common perception at the time, 
that Goldman Sachs was shorting mortgages big time while giving 
advice to clients?
    Mr. Killinger. Well, as I recall, in that time frame, there 
was some speculation in the press about that and I think that 
was kind of one of the points that was going around on Wall 
Street at that time.
    Senator Levin. But yet you hired Goldman Sachs in the end 
to help you out, is that correct?
    Mr. Killinger. We did use them on the transactions, yes.
    Senator Levin. Now, in your statement, Mr. Killinger, you 
described how the Office of Thrift Supervision was on site at 
WaMu and approved of WaMu's actions, like the decision to raise 
additional capital. You have mentioned them a number of times, 
always that they were kind of supporting or approving what you 
did. What you don't mention in your statement was the Office of 
Thrift Supervision's criticisms of WaMu.
    From 2004 to 2008, the Office of Thrift Supervision 
repeatedly leveled serious criticisms of the bank. Here are a 
couple samples.
    In 2004, ``several of our recent examinations,'' they 
wrote, ``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.'' That was May 12, 2004.
    In 2005, OTS wrote, ``Underwriting exceptions . . . 
evidence lack of compliance with bank policy. . . . 
Deficiencies, if left unchecked, could erode the credit quality 
of the portfolio. Our concerns are increased with the risk 
profile of the portfolio. . . .''
    In 2006, ``subprime underwriting practices remain less than 
satisfactory. Continuing weaknesses in loan underwriting at 
Long Beach.''
    In 2007, ``too much emphasis was placed on loan production 
at the expense of loan quality. Subprime underwriting practices 
remain less than satisfactory. Underwriting exceptions and 
errors remain above acceptable levels.''
    In 2008, ``poor financial performance exacerbated by 
conditions within management's control, poor underwriting 
quality, geographic concentrations in problem markets, liberal 
underwriting policy, risk layering.'' That was presented to the 
Board of Directors July 15, 2008.
    So year after year, you have OTS citing the bank for weak 
lending practices, and I am wondering, were you aware of those 
criticisms?
    Mr. Killinger. Yes.
    Senator Levin. I think, Mr. Killinger, in your opening 
statement, you made reference to Wall Street's growing appetite 
for these products. Can you expand on that?
    Mr. Killinger. I believe we were talking about back in the 
housing boom period?
    Senator Levin. Yes. And you were talking about your high-
risk products?
    Mr. Killinger. Yes. Well, clearly, the money was flooding 
into Wall Street both from international sources and domestic 
sources with a very strong appetite for buying various 
mortgage-related securities, and I think that very strong 
pressure to buy certainly had an influence on the products that 
they were willing to buy and ultimately the kind of conditions 
around those loans.
    Where we saw a particular change, I will say, is in the 
Option ARM, which for many years was a portfolio product and 
there was not a secondary market. What we saw in the mid-2000s 
is the emergence of a secondary market with Wall Street and 
Fannie Mae and Freddie Mac, and that led to a huge surge in 
brokers originating Option ARMs, and I think that certainly 
changed the competitive landscape for us. It caused us to lose 
significant market share and, I think, had an impact on the 
different competitive features of that product.
    So certainly the development of the secondary markets had a 
huge impact on that product. Similarly, it was the primary 
outlet for the origination of subprime loans, so that demand 
from Wall Street had, I think, a big impact on the criteria 
that were used to underwrite subprime loans.
    Senator Levin. And would you say that the criteria were 
looser as a result of that demand?
    Mr. Killinger. I don't think there is any question. You 
heard this morning about the layering--we can call it the 
layering of risk, where the loan-to-value ratios might have 
increased, where there was more of a prevalence of putting 
second mortgages on top of firsts at origination, less 
documentation of some new products in some cases, and very thin 
pricing because there was so much money kind of chasing, 
wanting to make those loans.
    Senator Levin. You say thin----
    Mr. Killinger. Yes, very low margins.
    Senator Levin. So there was this huge demand from Wall 
Street which, I think you would agree, contributed to the 
reduction in the criteria--the loosening of the criteria for 
these products.
    Mr. Killinger. I think that is absolutely the case.
    Senator Levin. Mr. Rotella, would you agree to that?
    Mr. Rotella. I would, Senator. I would also say that there 
were incredible incentives in the environment to leverage 
during this period. I also believe that there was a general 
belief that housing would not decline and institutions became 
excessively reliant on models that turned out to be wrong. So 
that drove a lot of Wall Street firms to look for yield, and as 
we have heard during the day, the GSEs had a dominant 
stranglehold on conforming product, and because the yields were 
so low on that product, there were other parts of the market 
that Wall Street and others looked to essentially chase yield.
    Senator Levin. I think Mr. Cathcart testified that Option 
ARM home sales depend on housing price appreciation for 
repayment through refinancing and are viable in a healthy 
market where housing prices are constantly on the rise. But 
when housing prices depreciate, Option ARMs become problem 
assets. Would you agree with that, Mr. Rotella?
    Mr. Rotella. I would.
    Senator Levin. And Mr. Killinger, would you agree with 
that?
    Mr. Killinger. Yes.
    Senator Levin. Well, I want to thank you for your 
testimony. We have a situation here where a bank, a mainstream 
bank and a Main Street bank began as a prudent, well-run bank, 
but it over time engaged in some high-risk and shoddy lending 
practices, early payment defaults, fraudulent information, 
unreasonable income statements, negatively amortizing loans. 
And then at the end, it became just a conveyor belt that 
dropped into the stream of commerce literally hundreds of 
billions of dollars of mortgages that were substandard and 
dubious. And it wasn't the only lender doing it. We know that. 
It was one of many. Together, these toxic mortgages contributed 
to a financial crisis in 2008.
    So we are now debating financial reform. We sure as heck 
need it. We are going to have three additional hearings in the 
next 2 weeks which will look at other aspects. It came up today 
about the question of the regulators. Where do they fall short? 
The credit rating agencies, where did they fall short? And the 
investment banks and Wall Street directly, what was their 
involvement? What was their role in this assault on our 
economy?
    We have to do some financial reform in the Senate. I hope 
that we are going to be taking action with respect to stated 
income loans that have no verification of income or assets. I 
hope we are going to take some action relative to negatively 
amortizing loans that hurt borrowers and increase the risk of 
default to stop that practice from occurring. We have to act on 
these high-risk loans that are the product of financial 
engineering, that are turned into these high-paying AAA 
mortgage-backed securities. The short-term Wall Street profits 
that have won for too many years over long-term fundamentals 
have cost this economy dearly.
    We heard a story today which is an in-depth story, which I 
think is a sad story, which cost the State of Washington and 
Seattle a lot of jobs there and around the country. It cost a 
lot of mortgages being foreclosed, and that resulted in a lot 
of homes lost, and were part of the problem that this economy 
faced that came to a head in 2008.
    So we will look at other parts of this in the 2 weeks 
ahead, but in the meantime, we want to thank our witnesses 
today for coming forward. We always appreciate people who are 
willing to testify, even when we have problems with that 
testimony. So we are grateful to the two of you.
    We will stand adjourned.
    [Whereupon, at 4:31 p.m., the Subcommittee was adjourned.]


                            A P P E N D I X

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