[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
U.S. GOVERNMENT PRINTING OFFICE
57-319 WASHINGTON : 2010
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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.
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\1\ See Exhibit No. 1j, which appears in the Appendix on page 224.
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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.
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\1\ See Exhibit No. 3, which appears in the Appendix on page 278.
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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.''
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\1\ See Exhibit No. 8a, which appears in the Appendix on page 388.
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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.
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\2\ See Exhibit No. 8b, which appears in the Appendix on page 389.
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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.
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\3\ See Exhibit No. 10, which appears in the Appendix on page 408.
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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\
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\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.
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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\
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\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.
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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.
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\3\ See Exhibit No. 1c, which appears in the Appendix on page 214.
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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\
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\4\ See Exhibit No. 79, which appears in the Appendix on page 793.
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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.''
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\1\ See Exhibit No. 30, which appears in the Appendix on page 544.
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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\
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\2\ See Exhibit No. 23b, which appear in the Appendix on page 511.
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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.''
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\3\ See Exhibit No. 22a, which appear in the Appendix on page 496.
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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.
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\4\ See Exhibit No. 24, which appears in the Appendix on page 515.
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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\
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\1\ See Exhibit No. 28, which appears in the Appendix on page 537.
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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.''
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\2\ See Exhibit No. 34, which appears in the Appendix on page 564.
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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\
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\1\ See Exhibit No. 35, which appears in the Appendix on page 569.
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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?
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\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?
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\1\ See Exhibit No. 16, which appears in the Appendix on page 448.
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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.
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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.
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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.
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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.
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\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.
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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?
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\1\ See Exhibit No. 78a, which appears in the Appendix on page 790.
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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.
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\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?
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\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.
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\1\ See Exhibit No. 3, which appears in the Appendix on page 278.
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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?
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\1\ See Exhibit No. 10, which appears in the Appendix on page 408.
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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?
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\2\ See Exhibit No. 13a, which appears in the Appendix on page 418.
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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?
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\3\ See Exhibit No. 19, which appears in the Appendix on page 462.
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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.
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\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.
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\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.
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\2\ See Exhibit No. 34, which appears in the Appendix on page 564.
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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?
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\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?
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\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.
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\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.
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\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.
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\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.
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\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.
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\1\ The prepared statement of Mr. Killinger appears in the Appendix
on page 179.
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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\
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\1\ See Exhibit 1i, which appears in the Appendix on page 223.
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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.
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\2\ See Exhibit 1c, which appears in the Appendix on page 214.
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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?
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\3\ See Exhibit 1b, which appears in the Appendix on page 213.
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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.
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\1\ See Exhibit 8b, which appears in the Appendix on page 389.
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``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.
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\1\ See Exhibit 11, which appears in the Appendix on page 414.
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``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.
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\2\ See Exhibit 12, which appears in the Appendix on page 415.
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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. . . .''
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\3\ See Exhibit 19, which appears in the Appendix on page 462.
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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?
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\1\ See Exhibit 79, which appears in the Appendix on page 793.
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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.
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\2\ See Exhibit 23b, which appears in the Appendix on page 511.
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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.
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\3\ See Exhibit 24, which appears in the Appendix on page 515.
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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.''
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\1\ See Exhibit 21, which appears in the Appendix on page 477.
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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.
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\2\ See Exhibit 33, which appears in the Appendix on page 553.
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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.''
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\1\ See Exhibit 30, which appears in the Appendix on page 544.
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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.''
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\2\ See Exhibit 31, which appears in the Appendix on page 546.
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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\
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\1\ See Exhibit 3, which appears in the Appendix on page 278.
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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.
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\1\ See Exhibit 39, which appears in the Appendix on page 628.
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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?
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\2\ See Exhibit 11, which appears in the Appendix on page 414.
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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?
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\1\ See Exhibit 50, which appears in the Appendix on page 670.
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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.''
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\2\ See Exhibit 78a, which appears in the Appendix on page 790.
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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.
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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.
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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.
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\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.''
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\1\ See Exhibit 6d, which appears in the Appendix on page 357.
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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.
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\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?''
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\1\ See Exhibit 40b, which appears in the Appendix on page 632.
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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.
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\1\ See Exhibit 69a, which appears in the Appendix on page 759.
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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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