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Originally published April 14, 2008 at 12:00 AM | Page modified April 14, 2008 at 6:34 AM

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Where WaMu went wrong

To keep growing rapidly, the Seattle company loosened its lending standards, took on shaky real-estate loans and lent money to risky mortgage brokers.

Seattle Times business reporter

When Washington Mutual's shareholders gather at Benaroya Hall on Tuesday, they'll confront a company in full crisis mode.

Seattle-based WaMu, one of the nation's biggest mortgage lenders and consumer bankers, lost money last year for the first time since 1984. Wall Street doesn't expect a return to profitability until sometime next year, if then.

Billions of dollars in tarnished debt sit festering on WaMu's books. The stock is down 71 percent over the past year, thousands of employees have been laid off, and just last week WaMu effectively sold half of itself to an investor group at a bargain-basement price.

WaMu executives, who declined to comment for this story, blame the company's troubles on the rapid unraveling of the U.S. housing boom last year, and investors' subsequent loss of appetite for most mortgage-backed securities. Though they saw the train coming, they say, they couldn't get off the tracks in time.

But interviews with former employees and Wall Street analysts, as well as reviews of internal documents and the company's financial history, suggest WaMu's crisis is largely of its own making.

While the housing and credit meltdowns have been hard on virtually everyone in the mortgage business, decisions made years ago by WaMu's leaders to loosen lending standards and raise the tolerance for risk left the company particularly vulnerable to swings in the housing and credit markets:

• WaMu aggressively stepped up its lending in some of the riskiest loan types: short-term adjustable-rate mortgages, especially so-called "option ARMs"; home-equity loans and lines of credit; and subprime loans. Over the past four years, more than half of all real-estate loans WaMu made were in one of those higher-risk categories.

• WaMu made billions of dollars' worth of loans with only "limited documentation" of the borrowers' income, net worth or credit history. Such loans — often called "liar loans" or "NINJA loans," for "no income, no job or assets" — make up three-quarters of its $58.9 billion option-ARM portfolio.

• Complaints from appraisers and an investigation by New York's attorney general say WaMu leaned on appraisers to inflate property values to support bigger mortgages.

• In August 2004, WaMu loosened its standards for fronting money to third-party mortgage brokers, allowing brokers with heavier debt loads to make more loans.

WaMu, in public statements and investor presentations, stresses it first warned of a housing bubble in mid-2005 and sold billions of dollars' worth of the riskiest mortgages off its books. But it continued to make new higher-risk loans at a fast clip until well into 2007 — when the resale market for them abruptly evaporated.

As a result, at the end of last year more than 56 percent of WaMu's loan portfolio, $138.4 billion, consisted of option ARMs, home-equity loans and subprimes. One analyst estimates that, largely due to such loans, more than $16 billion in future losses are embedded in WaMu's books.

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And in 2005, when WaMu decided it needed to diversify beyond the mortgage business, it bought a credit-card company, Providian Financial, that targeted "subprime" customers — those with weaker credit histories. Now, with the economy in or near recession, credit-card defaults also are rising.

Quantity, not quality

WaMu was hardly the only lender to loosen its lending standards during the boom, of course. But for Seattleites, it isn't another mortgage chop-shop like Countrywide Financial or New Century.

It's the 119-year-old thrift that taught generations of Seattle schoolchildren how to save through its "Bank Day" program, the homegrown institution with the folksy attitude whose ads for years featured Ellensburg's "Rodeo Grandmas."

But that's not the face WaMu presented to Wall Street investors. To them, it was a nationwide financial-services powerhouse that aimed its checking accounts, mortgages and other products squarely at Middle America.

"The DNA of the company is to grow," said Richard Bove, veteran banking analyst for Punk, Ziegel & Co. in Florida. "It's always emphasized growth over all other aspects of its business."

When that growth slowed, Bove added, "they had to reach down to a new level of the marketplace. They had to seek out a lower quality of customer than they were used to dealing with."

In the early years of this decade, record-low mortgage rates set off the biggest refinancing boom in U.S. history.

Internal mishaps

But WaMu, despite being one of the nation's biggest home lenders, struggled to increase profits because of operational missteps — incompatible technologies inherited from numerous acquisitions, a bungled hedging program, and delays in processing loan applications.

In an Oct. 21, 2004, conference call, Chief Executive Kerry Killinger assured analysts and investors WaMu was turning around its lagging mortgage division.

A key initiative, he said, was writing a lot more adjustable-rate mortgages, or ARMs — especially option ARMs, a relatively new type of loan.

With standard fixed-rate mortgages, the monthly payment is set to pay off both the loan balance and interest within the term of the loan — typically 30 years. With ARMs, as the name suggests, the interest rate on the principal balance resets periodically.

Option ARMs add yet another wrinkle: Each month, borrowers can choose whether to pay down both principal and interest, the interest only, or to make a minimum payment so low that their loan balance actually rises — called "negative amortization" or "neg am."

Option ARMs proved extraordinarily popular during the housing boom. Between April 2004 and the end of 2007, WaMu underwrote $184.8 billion of them, along with $9.5 billion of other short-term ARMs (those in which the rate resets within a year).

All told, short-term ARMs made up nearly a third of all home loans WaMu originated in that period.

The company earned hefty fees for bundling the loans and selling them off to investors; the neg-am feature also swelled WaMu's coffers.

In 2006 and 2007, about half of all option ARM borrowers made minimum neg-am payments. Far from disappearing, those skipped interest and principal payments were added to the total amount borrowers owed and became assets on WaMu's balance sheet: The company booked nearly $2.5 billion in 2006 and 2007.

Flagship product

"The option-ARM product," Killinger said on the conference call, "is a key flagship product for our company."

Unfortunately for WaMu, its flagship was precisely the kind of loan most prone to sour once the housing boom ended, mortgage rates started going up, and borrowers couldn't make their payments, refinance their loans or sell their houses.

And despite selling off hundreds of billions of dollars' worth of option ARMs to outside investors (who now are watching them blow up at alarmingly high rates), WaMu still has $58.9 billion of them on its books.

About $44 billion of those loans were made using the "limited documentation" standard, under which borrowers don't have to provide the full range of financial disclosure typically required of conventional borrowers.

In an e-mailed statement, a WaMu spokeswoman said the bank's option-ARM borrowers must "show they can afford" the payments when the interest rate resets after the discounted introductory period. She did not respond to a follow-up inquiry about how borrowers could demonstrate that without proving their income, assets or credit history.

The company acknowledges in its annual report that such loans are more prone to go sour during economic downturns.

Lowering the bar on risk

WaMu's greater risk tolerance wasn't confined to the loans it made itself.

In 2004, Dale George was a WaMu senior credit-risk officer in Irvine, Calif. Part of his job entailed assessing the financial condition of outside mortgage brokers to whom WaMu lent money to make loans.

Such "warehouse lending" brought in billions of dollars in loans for WaMu to bundle up and resell.

In an interview, George recalled he was asked to look at one Pennsylvania brokerage that did a lot of subprime business and was up for a $5 million loan.

Because the firm's revenues and profits had fallen sharply, and because George believed the real-estate mania was already getting out of hand ("When things go south, they go south very quickly," George said), he recommended downgrading the firm's risk rating.

That would have required WaMu to set aside money in case the brokerage couldn't repay its loan.

His bosses weren't pleased.

"They told me, 'Just do the write-up and sign off on it,' " he said. "We're independent, internal auditors; we're not supposed to do things like that."

Ultimately, George said, his supervisor "literally grabbed the file out of my hand and said, 'I'll deal with this with somebody else.' " The deal ultimately went through, he said, but several months later WaMu severed ties with the firm over other issues.

George was fired two years later after questioning several other loans. Now employed by U.S. Bank in California, he has sued WaMu for age discrimination and unlawful retaliation. The case is in arbitration. WaMu declined to comment on his allegations.

Documents George provided to The Seattle Times indicate the company eased its risk standards for outside mortgage brokers — particularly regarding their leverage, or debt as a multiple of net worth.

According to the old standards, brokers with more than $10 of debt for every dollar of net worth fell in the "watch" category, calling for a 1 percent loss reserve. More than $15 of debt for each dollar of net worth meant their loans were considered "impaired" calling for 5 percent of the loan amount to be put in WaMu's loss reserve.

But WaMu revised its rules in August 2004 to make acceptable any leverage ratio of 15-to-1 or less. The 5 percent reserve requirement wouldn't kick in until the broker had more than $20 in debt for every dollar of net worth.

For example, under the older, more conservative risk-rating system, a $10 million loan to a broker with a 15-to-1 debt ratio carried a $500,000 loss reserve. Under the new system, only $60,000 had to be set aside for potential future losses.

The effect, George said, was to spur even more third-party lending on WaMu's behalf as real-estate frenzy intensified.

"All the stuff that's happening now, we knew this was going to happen two years ago," he said. "Even though there was weakness in the market, they put their foot on the accelerator, because they were losing business to Countrywide and other lenders."

Eager buyers

Why was WaMu so eager to generate more and more mortgage loans? Because it could easily package them into bonds — a process called securitization — and sell them off to hedge funds and other institutional investors.

Indeed, during the housing boom, investors couldn't get enough mortgage-backed securities.

As lenders such as Countrywide and New Century Financial reported ever higher profits by generating and securitizing loans, analysts say, WaMu felt pressured to keep up.

But even with more than 2,000 branches in 15 states, said Jim Bradshaw of D.A. Davidson brokerage, WaMu didn't have enough cheap funding — in the form of savings and checking accounts — to write all the loans it wanted.

Instead, it chose to loosen its own lending standards, buy loans from other banks and pay independent brokers to hustle up loans on its behalf.

"It was easier to gear up on the [loan] production volume than it was to build branches," Bradshaw said. "They were building new branches like crazy for a while, and they still couldn't grow deposits at the same rate they were growing loans."

Unfortunately for the buyers of those securitized mortgages, the performance steadily deteriorated as the housing boom reached — then passed — its bursting point last year.

For analyst Bove, all this has a familiar ring: The mortgage business went through a similar, though smaller, boom-and-bust in the early 1990s.

"All of these companies run into the same problem — which is, ultimately, that poor people can't pay above-market mortgage rates," he said. "But every cycle, companies think they've figured out a way to underwrite these loans."

Drew DeSilver: 206-464-3145 or ddesilver@seattletimes.com

Copyright © 2008 The Seattle Times Company

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