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Originally published September 14, 2008 at 12:00 AM | Page modified September 22, 2008 at 7:00 AM

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On the Economy

Lessons to be learned from how WaMu lost its way

When it comes time to write the history of Washington Mutual, it may rival Tom Wolfe's "Bonfire of the Vanities" for the blindness, arrogance and greed of the Masters of the Universe running the place.

Special to The Seattle Times

When it comes time to write the history of Washington Mutual, it may rival Tom Wolfe's "Bonfire of the Vanities" for the blindness, arrogance and greed of the Masters of the Universe running the place.

For now, we have a fast-developing drama of survival. And some lessons:

1. Never confuse brains with a bull market (or a successful Ponzi scheme). The go-go years of Washington Mutual and its once-lionized chief executive, Kerry Killinger, coincided with the financial-services boom of the 1990s, which included a big push for banks and thrifts to expand or be bought and the housing mania of the early 2000s. Both were unsustainable, and yet they were the lifeblood of WaMu's rising stock price.

As housing took off, Washington Mutual became a leader in turning mortgages from a prudent process involving a loan officer into a production line feeding Wall Street's ravenous demands for short-term profits.

Standards were relaxed and WaMu accumulated billions of dollars in high-risk mortgages, including the infamous liar's loans, where real information about a customer's financial situation was, um, optional.

The production line at WaMu and elsewhere fed the greatest suburban sprawl boom in history, as building homes appeared to be America's last invincible factory operation.

It fed the speculation of even low-wage workers with their rental houses and, especially, Wall Street, where the mortgages were repackaged and sold to investors. It seemed brilliant and everybody was getting rich, but only as long as house values kept rising.

In fact, the boom was simply a Federal Reserve-driven, once-in-a-lifetime phenomenon: a bubble created as the value of assets grew faster than the cost of borrowing.

In essence, then-Fed Chairman Alan Greenspan had built the world's largest Ponzi scheme. And like all such enterprises, it came to grief. Given its size, it's not surprising that some measures of damage are the worst since the Great Depression.

Now the fragile capital markets are groping toward revival in areas such as commodities and help from overseas investors.

They're not buying what WaMu is selling: neither the mortgage-production line nor the vast, illiquid toxic dumps of debt. And the fallout in jobs and consumer well-being even threatens WaMu's hopes for its retail-banking operations.

2. When in a hole, stop digging. WaMu continued to make large numbers of risky home loans well after it was clear not only that a housing bubble was emerging, but that it had popped. In a September 2007 speech, Killinger is quoted as saying this, "frankly, may be one of the best times I've ever seen for taking on new loans into our portfolio."

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That was a month after the Fed was forced to make a surprise rate cut to steady credit and stock markets that were poleaxed by mounting mortgage losses.

Executives may have been betting they would snap up better-quality mortgages and gain market share, but the market was already deteriorating so fast that trouble was spreading beyond subprime loans.

Like many homeowners it lent to, WaMu couldn't say no, didn't know when it was in over its head. Unlike homeowners, though, it was led by well-paid experts who still believed in those famous last words: The numbers made sense. But it was worse: the behavior of the addict, the gambler who still thinks he can win back irretrievable losses.

3. Growth is perilous. No less an authority than Hugh McColl Jr., who built a middling North Carolina franchise into Bank of America, said that growing can be the toughest and most dangerous test for a company. Organizations can become distracted. Integrating cultures and technology is difficult. And promising acquisitions can prove to be dogs.

Washington Mutual grew substantially by acquisitions, some handled well but a few proving more challenging, such as its 2001 purchase of Dime Bancorp. The branch network and, critically, the loan portfolio were grown fast and carelessly.

It may be that Washington Mutual reached a tipping point where it was simply too large as a traditional savings and loan, heavily dependent on home loans and consumer accounts, and needed to make the transition to being a commercial bank. It didn't.

4. Regulators slept deeply. The federal Office of Thrift Supervision is now closely monitoring Washington Mutual, which had a chilling effect on its stock this past week. As recently as June, the company had said it was "not currently in such discussions with any regulatory agency."

Federal bank and thrift regulators had taken a hands-off approach to the industry during most of the Bush presidency, as part of the conservative view that markets are self-correcting.

Yet the financial-service industry also successfully lobbied Democrats as well as Republicans to deregulate it in the 1990s, this despite the $130 billion in tax dollars spent (at the time) to bail out the savings-and-loan industry. Major banks were actually training regulators in how their complex new investments worked.

As a result of these weaknesses, as well as inadequate real-time information on the condition of institutions, regulators didn't stop unsound practices when the damage could have been limited.

Now they have been forced into unprecedented and costly interventions, such as saving Fannie Mae and Freddie Mac. Suddenly all those tough laws from the Great Depression seem like a good idea.

5. Corporate governance broke down. The missteps of Killinger and his management team have been well-documented.

Equal blame must go to Washington Mutual's board, which has been portrayed in some national media as local-yokel cronies of Killinger.

Unfortunately, a board in thrall of the star CEO remains all too common in many U.S. corporations.

Most American CEOs also hold the title of chairman of the board, an inherent conflict of interest. Directors should represent shareholders and hold management and the CEO to account.

WaMu's governance failures are multiple, including failing to scrutinize Killinger's expansion strategy, ask tough questions about relaxed lending standards and reign in the growing portfolio of time-bomb loans.

The board's ultimate sin was failing to remove Killinger far earlier.

Shareholders now get to pay his successor a $7.5 million signing bonus while seeing their stock hit a 17-year low.

6. Do you really want your (taxpayer-insulated) banker to be a risk-taking innovator? The aggressive, risk-taking innovator is the ideal of American business today. As the price tag is totted up for the likes of Countrywide and IndyMac, at one time seen as leading innovators in financial services, Americans might wish for a return to the stodgy old banker of the past.

Facing the greatest debt overhang in U.S. history, they should demand it.

As long as the housing bubble was rising, Washington Mutual was rewarded on Wall Street for taking risks with its loan portfolio. Those reviled option ARMs were once celebrated.

The allegation of leaning on appraisers to inflate house values and loosening standards to pump the boiler rooms of third-party brokers — why, that was just aggressive risk taking.

Yet this was not Microsoft or Starbucks. Executives were implicitly gambling while knowing they were ultimately insulated by federal deposit insurance. Economists call this moral hazard.

Now the haz-mat crews are at work. Seattle might get lucky if a group of local investors tried a Sonics-style rescue, buying the retail bank and keeping this important headquarters here.

For now, though, in the rough justice of the market, the same Wall Street that demanded Washington Mutual take risks to keep the loans coming is now betting against its onetime darling.

Jon Talton is a journalist and author living in Seattle. For more than 20 years he has covered business and finance, specializing in urban economies, energy, real estate and economics and public policy. You may reach him at jtalton@seattletimes.com

Copyright © 2008 The Seattle Times Company

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About On the Economy
Jon Talton comments on economic trends and turning points, putting them into context with people, place and the environment in the Pacific Northwest
jtalton@yahoo.com

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