In a more sober world, the findings uncovered in the two-year investigation led by Sens. Carl Levin, D-Mich., and Tom Coburn, R-Okla., would end any discussion about whether financial firms committed crimes leading up the housing bust. That's not to say that the crash of 2008 is as simple as an episode of "Law & Order." But it's often not that much more complex. Because if the nearly 640-page report makes anything clear, it's this: Fraud was at the heart of the financial crisis. (It also confirms that dishonest borrowers are not the problem -- lenders are.)
Mortgage fraud. Securities fraud. Disclosure fraud. Fraud ignored or buried. Fraud conceived in boardrooms and focus-tested on bank customers and employees. And for all the eye-glazing complexity of synthetic collateralized debt obligations and other effluvia of the financial crisis, this fraud was often quite straightforward. To get a sense of how it was done, the case of Washington Mutual, which has a starring role in the report, is instructive.
Pass the Wite-Out
Several years before WaMu blew up in 2008 -- making it the biggest bank failure in U.S. history -- an internal investigation at the lender found that more than 80 percent of the loans issued by two of its loan officers were fraudulent. Eighty percent!
The fraud included misrepresentations of income and employment, false credit information, false residency claims and bogus property appraisals. It involved schoolboy tricks like whiting out parts of a borrower's loan application form or faking people's signatures. Additional fraud was found in other branches. A top WaMu executive later told Senate investigators that the level of fraud was "eye-popping."
What did the company do upon discovering these crimes? Nothing. No one was fired. No one was even disciplined. No anti-fraud program was installed. Nothing was ever mentioned to the financial regulator that oversaw WaMu.
No investors who bought mortgage-backed securities containing fraudulent loans issued by the company were ever alerted or got an explanation about what might be causing so many of the loans to sour. When the risk management exec who had overseen the probe retired, his replacement at WaMu was never informed of the investigation.
Commit fraud, win a Hawaiian vacation
Over the next two years, the same WaMu loan officers known by the lender to have committed fraud continued making loans. Some won trips to Hawaii for all their hard work.
Eventually AIG, which insured some of the thrift's residential mortgages, complained to WaMu execs that it was finding fraudulent documents in the company's loans. Another investigation was conducted, this time at the request of WaMu's federal regulator, the Office of Thrift Supervision. More than 60 percent of the loans issued by the same branch that previously had been caught passing bad loans were discovered to be fraudulent.
By this time, though, it was 2008. WaMu was awash in mortgage-related losses. The FDIC seized the company in September and sold it to JPMorgan Chase (JPM), although not before WaMu could borrow billions of dollars from the Federal Reserve, including $2 billion the day it failed. And what became of the WaMu employees that had sold the bad loans? This:
The two loan officers heading those offices left the bank and found other jobs in the mortgage industry that involve making loans to borrowers.Are you ready for some football?
Another main element of the fraud at WaMu was its strategy to push Option-ARM loans -- the kind that come with a low teaser interest rate and then later reset at a much higher rate -- on people with good credit. WaMu execs were well aware that such loans were hugely risky, not only for customers but also for lenders. They wanted to sell them -- especially to prime borrowers -- because such loans were far more profitable than ordinary fixed-rate mortgages. And here's how WaMu did it.
The key, the company realized, was convincing people to bypass a conventional, low-risk loan in favor of an Option ARM. So in 2003, WaMu began testing its approach to selling these loans on customers. A companion study focused on how effective the thrift's loan consultants and third-party mortgage brokers were in selling Option ARMs.
What the company found is that it was actually pretty hard to sell Option ARMs. They made loan officers and borrowers nervous. As the Senate report describes:
[WaMu] noted that Option ARM loans had to be "sold" to customers asking for a 30-year fixed loan, and training was needed to overcome the feeling of "many" WaMu loan consultants that Option ARMs were "bad" for their customers.To overcome such resistance, WaMu boosted loan staffers' sales commissions on the loans. It also conducted what the thrift called "blitzes," in which loan personnel who increased the proportion of Option ARMs they sold by at least 10 percent would get a bigger bonus.
Staying with the pigskin theme, WaMu in 2006 held a "Fall Kickoff" contest in which loan consultants who scored the most points would get a reward. Selling an Option ARM was worth a "touchdown" (and extra point), or seven points; jumbo-fixed, equity and nonprime mortgages were worth a "field goal," or three points. The prize? A $100 gift card.
The $100 million man
As for borrowers, a key technique for getting them over their aversion to Option ARMs was to conceal what their monthly payments would be once the loan reset. It worked. In one year WaMu more than doubled its Option ARM originations. By 2006, it was the second-largest purveyor of these loans in the country, selling or securitizing some $115 billion in Option ARMs in a single year.
By passing many of these loans on to investors in the form of secrurities, of course, WaMu was infecting the entire financial system with fraud. As the bottom fell out of the housing sector, up to half of the loans went bad.
As the main architect of this strategy, WaMu CEO Kerry Killinger got more than a gift card. Between 2003 and 2008, his total pay was nearly $100 million. He also got four retirement plans, a deferred bonus plan and a separate deferred compensation plan. When he was effectively fired in 2008, Killinger received an additional $25 million.
Feeling woozy yet? I know I am. Levin plans to refer his findings to the Justice Department and SEC in hopes that they will finally take action against financial execs who acted as criminally, or worse, than WaMu leaders. But the will in Washington for such prosecutions is weak. There is, after all, an economy to fix.
Image from Wikimedia Commons
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