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Originally published Sunday, September 21, 2008 at 12:00 AM

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Big dreams of WaMu dashed by risky loans

Former CEO Kerry Killinger's dream of turning WaMu into a coast-to-coast Wal-Mart of household finance has crumbled.

Seattle Times business reporter

Washington Mutual CEO Kerry Killinger stood before a Wall Street investors' conference last September and declared that his company — the company he had led since 1990 and built into the nation's sixth-largest bank and one of its biggest home lenders — not only would survive the collapse of the mortgage bubble but would prosper.

Despite what Killinger called "a near-perfect storm" in the U.S. housing market, he said, "We have appropriate capital and sources of liquidity (i.e., cash) to weather the storm."

Killinger declared that WaMu would add billions in new mortgages to its books, in a bid to gain market share. "This, frankly, may be one of the best times I have ever seen for taking on new loans into our portfolio," he said, especially "as weaker competitors close down or finally fess up that they need to adjust capacity to current reality."

Just over a year later, Killinger's dream of turning WaMu into a coast-to-coast Wal-Mart of household finance has crumbled.

The CEO himself is gone, ousted by the board earlier this month. And even after bouncing 42 percent Friday, the stock has lost 88 percent of its value since his speech, as traders question whether the Seattle-based thrift can access enough cash to stay in business. The company now is seeking to sell all or part of itself to the highest bidder.

How did things come to this? How could WaMu, which at its peak in mid-2006 was valued by the stock market at nearly $44 billion (it's worth about $5 billion now), tumble so far so fast?

The answer, stripped of the lingo of high finance, is simple: WaMu loaned too much money to people who couldn't afford to pay it back.

From 2004 to the end of 2007, WaMu made $452.5 billion in some of the riskiest types of home loans: subprime loans, home-equity loans and short-term adjustable-rate mortgages, especially so-called "option ARMs," which allowed people to choose how much they wanted to pay each month.

Many borrowers, unsurprisingly, chose to pay as little as possible. Like credit-card users making only the minimum monthly payment, they ended up owing more than they'd originally borrowed.

All in all, more than half of WaMu's real-estate loans during that period were in one of those three categories. And they were the kinds of loans most likely to go sour once the housing boom cooled and the economy started to sputter.

The subprime loans were the first to curdle, in the first half of 2007. Home-equity loans were next, in the second half. This year, it's been the option ARMs.

In addition, 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" — made up three-quarters of WaMu's option-ARM portfolio at the end of 2007.

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WaMu, in public statements and investor presentations, has said it first warned of a housing bubble in mid-2005 and sold billions of dollars' worth of the riskiest mortgages off its books. That's true. However, it continued to make new higher-risk loans at a fast clip until well into 2007.

Why would any lender concerned about its fiscal health stay on the wilder edges of the mortgage business even after the housing market peaked? Because until mid-2007, lenders like WaMu were able to package up pretty much any mortgages they made and sell them off to hedge funds, pension funds, insurance companies and other financial firms.

Those packages, called mortgage-backed securities, were sliced up, repackaged and resold so many times that, as often as not, institutional investors weren't sure entirely what they owned. But as long as the housing market bubbled along, no one much cared.

But as mortgage defaults and foreclosures rose sharply in 2007, the resale market for home loans and the securities based on them abruptly evaporated. Because no one could readily assess how much default risk those loans carried, no one wanted them. And that meant lenders like WaMu were stuck with billions of dollars in suspect loans with no way of getting them off their books.

As a result, as of the end of June, nearly 54 percent of WaMu's $239.6 billion loan portfolio consisted of option ARMs, home-equity loans and subprimes.

There were other issues, too. According to complaints from appraisers and an investigation by New York's attorney general, WaMu leaned on appraisers to inflate property values to support bigger mortgages. And 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.

Within a few months of Killinger's speech, WaMu reversed course and began ratcheting down its mortgage lending and it has laid off thousands of workers.

The company has shut down its free-standing home-loan offices, ceased buying loans from outside mortgage brokers, stopped making subprime loans and option ARMs, and reduced how much its home-equity customers can borrow.

But there are still a lot of bad loans on WaMu's books, and no one knows how far the rot goes.

So far this year, WaMu has written off more than $3.5 billion in loans, compared with $1.62 billion for all of 2007; earlier this month it said it would write off another $2.6 billion or so for the third quarter, which ends Sept. 30. The company's own estimate is $19 billion in mortgage-related losses over the next few years, though many outside analysts say even that figure is too low.

As of June 30 WaMu had nearly $8.5 billion set aside to cover its bad loans, and it has said it will set aside another $4.5 billion in the third quarter. But the markets are worried that won't be enough.

Even if WaMu does have enough available capital to meet its business needs, the fear and uncertainty dominating the markets put almost irresistible pressure on it to make a big move — though the sweeping mortgage-securities bailout plan announced by federal officials Friday may have bought the company some time.

So the thrift finds itself with a menu of unappetizing choices: Raise more cash from outside investors, if any can be found, at the cost of diluting the value of its current shareholders' stakes. Sell part of the company and hope the proceeds are enough to keep the rest afloat.

Or throw in the towel and sell the whole company for whatever it will fetch.

Drew DeSilver: 206-464-3145

Copyright © 2008 The Seattle Times Company

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