Yesterday, the U.S. Senate Permanent Subcommittee on Investigations, under Chairman Carl Levin (D-MI), and Ranking Member Tom Coburn (R-OK), launched a series of hearings to examine the roles played by high-risk mortgages, regulators, credit rating agencies and Wall Street investment banks in the financial crisis. Yesterday’s hearing, titled “Wall Street and the Financial Crisis: The Role of High Risk Home Loans,” focused on the role of high risk mortgages through a detailed study of the failure of Washington Mutual Bank (WaMu). WaMu was the nation’s largest thrift and in 2008 became the biggest bank failure in U.S. history.

Testifying before the subcommittee were:

Panel 1:

  • James Vanasek, former Chief Risk Officer, Washington Mutual Bank (2004-2005)  
  • Ronald Cathcart, former Chief Risk Officer, Washington Mutual Bank (2006-2008)  
  • Randy Melby, former General Auditor, Washington Mutual Bank  

Panel 2:

  • David Schneider, former President of Home Loans, Washington Mutual Bank  
  • David Beck, former Division Head of Capital Markets, Washington Mutual Bank  

Panel 3:  

  • Stephen Rotella, former President and Chief Operating Officer, Washington Mutual Bank  
  • Kerry Killinger, former President, CEO and Chairman of the Board, Washington Mutual Bank  

In his introductory statement, Chairman Levin presented an overview of the financial crisis and WaMu’s role, emphasizing that “the recent financial crisis was not a natural disaster. It was a man-made economic assault.” He discussed the findings of the subcommittee, which, he said, reviewed millions of pages of documents (certain of which were released by the subcommittee) and conducted more than 100 interviews and depositions as part of its investigation, which started in November 2008. He discussed WaMu’s conscious decision to focus on high-risk loans such as subprime loans and option ARMs, which offered greater profit potential. Most of these high-risk loans were then securitized and sold to investors.

Chairman Levin outlined the subcommittee’s findings that WaMu associates were rewarded for writing these high-risk loans. Associates were not only rewarded financially, through pay policies focusing on the volume of loans originated rather than quality and being paid more for originating higher risk loans, but were also told to “get the loans whatever it took.” He also discussed how the subcommittee’s investigation uncovered documents showing fraud in the completion of applications for many of the loans, including internal reports showing that many of the loans did not comply with the bank’s internal credit requirements and several contained fraudulent or erroneous information, such as manufactured assets or income to help the borrower qualify for such loans. The investigation further showed that, at times, WaMu selected loans for securitization because they were likely to default or had been identified as containing fraudulent information, said the Chairman, and this information was not disclosed to investors.

Chairman Levin remarked that “the goals of the subcommittee hearing are threefold — to construct a public record of the facts in order to deepen public understanding of what happened and hold some of the perpetrators accountable; to inform the ongoing legislative debate about the need for financial reform; and to provide a foundation for building better defenses to protect Main Street from the excesses of Wall Street.”

Questions for the first panel focused on WaMu’s decision to shift to a high-risk lending focus even though the subprime market had already been internally identified as a “bubble.” The subcommittee also asked questions about the “systemic fraud” that went uncorrected at Long Beach Mortgage Company (Long Beach) (a subsidiary of WaMu and WaMu’s principal subprime channel). The panelists explained that they often identified these risks and suggested corrections that went unimplemented. They further testified that they did not have authority to implement the corrections but only to point out the problems to those who did have the authority. Mr. Vanasek noted that much mortgage fraud, such as misstatements of income or net worth, is “extremely hard to catch” and detection requires the support of those immediately supervising the loan originators. Thus, even if they suspected mortgage fraud, they could not always prove it. Vanasek said he had tried to cap the percentage of high risk and subprime loans in the thrift's portfolio but was ignored and circumvented by lower-level managers. When asked by Chairman Levin whether WaMu had effective risk management review for its subprime lending affiliate, Vanesek responded, “no sir, they did not.”

Questions for the second panel focused on Long Beach’s continued violations of WaMu’s underwriting guidelines and failures to accurately report exceptions to WaMu policy. The subcommittee asked whether investors were informed of fraudulent loans when these loans were securitized and sold to investors. Mr. Schneider testified that neither he nor the underwriting and audit groups were happy with the problems at Long Beach. He further testified that, shortly after he took over responsibility for Long Beach’s mortgage loans, the subsidiary was incorporated into the home loan business line of WaMu and the operations were shut down. Mr. Schneider testified that he did not follow up to ensure that investors were notified of fraud in the securities that they were buying but that he did take efforts to terminate those responsible for the fraud.

Mr. Beck testified that he was not aware of the extent of the fraud risks or underwriting defects associated with WaMu’s high-risk loans when his office securitized them. Further, he testified that it was his understanding that the loans identified as having fraud and underwriting problems would not be a part of the securitized loans but that he did not confirm that these mortgages had been removed from the secured pool, as that was not his responsibility. When it was learned that WaMu had securitized loans that were delinquent, however, the repurchase and recovery team repurchased these loans from investors, testified Mr. Beck.

The focus of questions for the third panel were similar as those for the first two panels, focusing in part on whether the former executives were aware of the documented fraud connected with the Long Beach loans and whether they took steps to make investors aware of the fraud and high delinquency rates of the loans. Mr. Killinger testified that he would have referred any fraud known to him to WaMu’s legal department. He further testified that he was sure that WaMu had taken whatever actions were prudent to inform investors of these issues as required by regulators.

Mr. Rotella testified that there were many organizational and systems problems with the mortgage business when he joined WaMu. Regarding the underwriting and fraud problems at Long Beach, he testified that when the extent of the problems at Long Beach became apparent, he responded, in his role as chief operating officer, by “taking out management, restructuring the business, taking down volume, and ultimately, shutting [Long Beach] down,” all of which he believed were proactive responses.

When asked why he thought WaMu was seized, Mr. Killinger echoed his prepared testimony by stating that regulators had not treated WaMu in “the same equal handed, fair manner that other financial institutions were” treated. According to Killinger, the seizure was “unnecessary” and was sold at a “bargain price.” In his view, WaMu would have survived had it been “treated in the same equal-handed, fair manner that all other financial institutions were,” claiming that institutions receiving support were “part of the inner circle and ‘too clubby to fail’.”

A second hearing on “Wall Street and the Financial Crisis” will be held on Friday, April 16. It will look at the role of regulators in the 2008 financial crisis.