Washington Mutual: Big Dreams, Poor Implementation

The Washington Mutual has its origins in Seattle. It was meant to offer its stockholders a safe and profitable investment avenue. In 1917 it became the Washington Mutual or WaMu for short. It had one of the most solid and strong savings bases in the country. Its growth was further fuelled by adopting the latest innovations in financial technology. The bank went public in 1983 and in the span of six odd years doubled its assets. Under the leadership of its CEO Kerry Killinger, the bank acquired 16 smaller banks, thus becoming a banking behemoth.

Washington Mutual hoped to be a financial supermarket for retail and commercial consumers. In an attempt to improve slow growth WaMu acquired Long Beach that provided mortgages for people with poor credit history. In 2005 WaMu acquired Providian, a lender of credit cards to customers who could be termed subprime. [1]Providian used a mathematical model, wherein it issued cards to customers who could pay the monthly charges, but not the high rate of interest on the total debt. In the event of slowing sales, they doled out cards to lower than subprime customers who in normal circumstances would not be eligible for any debt. Providian sold to WaMu after a host of claims of falsely deceiving and overcharging its customers were made against it. [2] WaMu was seeing a slowing of its home loan business and wanted to enter the credit card business, hoping to gather at one stroke Providian’s 9.5 million customers. WaMu aimed at lowering the cost of funds by using its retail deposit base. WaMu continued to see a decline in the mortgage sector. It saw its traditional sources of revenue such as deposits; loan advancement and fee based services reduce. Its assets were increasingly funded by the market or Federal home rates. 20% against the prescribed 15% were funded in this manner.

Default rates soon started increasing. By 2007 this rate was only increasing, putting increasing pressure on WaMu. As its assets spoilt, the bank increased its provision to buffer this loss by almost 480% from the previous year. It cut its dividends by 73% and workforce by 3000. Allegations that WaMu pushed for inflated higher home appraisals came under State scrutiny.

In 2008 WaMu reported losses - "to be at the upper end of the range" it disclosed in April of $12 billion to $19 billion and that 2008 should be the "peak year" for provisioning. Firm-wide net charge-offs totaled $2.2 billion in the second quarter. Nonperforming assets totaled 3.62% of total assets compared with 2.87% at the end of the first quarter, the bank said.

However as the housing crisis raged on, WaMu faced a severe credit crunch, borrowing as much as $7 billion from TPG. [3]The bank faced with defaults tried to reduce costs by lowering the number of branches, but its losses on credit cards and mortgages burgeoned. Rising inflation further increased the losses in its credit card business.

After Lehman Brothers collapsed, WaMu depositors started withdrawing money. WaMu was being pressurized by the Fed Reserve and Treasury department to sell its business. The process reached a deadlock with WaMu management unhappy with the bids it received. The Government then to redeem the massive negative impact the fall of WaMu would have on the economy, brokered a deal with JP Morgan Chase. Its shares were sold for pennies where they were once valued in dollars. A restructured entity was sold to JPMorgan Chase while WaMu filed for bankruptcy. WaMu chose to forget the principles it was built on. It sacrificed its strengths at the altar of fast growth at any cost, bringing to an end a century plus old bank.

Its owners and management have denied willful ill-doing on their part. WaMu begins its second chapter as WMI holdings, in its new avatar as a mortgage reinsurer.

Washington Mutual’s descent into financial ignominy brings into focus the role of regulators and banks alike. [4]The WaMu was supposed to be overseen by the OTS or Office of Thrift Supervision. Permanent Subcommittee on Investigations, Chairman Carl Levin (D-Mich.) called OTS a watchdog without a bite.

The financial firms "couldn't have done what they did unless their regulators let them," Levin said. He listed several examples in which the Office of Thrift Supervision knew of serious problems in loan quality and risk management at WaMu, but did too little too late. He also blamed The Federal Deposit Insurance Corp., the bank's back-up regulator, for not taking action to keep WaMu in check. Regulators "had a front-row seat to Washington Mutual's high-risk lending strategy, its poor quality loans, its substandard securitization practices, but did little to stop it," he said.

[5]WaMu left best practices far behind when it started to aggressively expand. It specialized in lending risky loans that were short term and with adjustable rates called ARMs. Over 50% of its home loans were in this category.

It also lent loans to individuals with low income, no assets and no job also known as Ninja or Liar loans. This constituted up to 75% of its ARM loans.

The errors that brought about WaMu’s downfall can be summarized as follows:

The clear lack of pricing risk into lending decisions resulted in credit risk

WaMu did not undertake a realistic provisioning for losses. This again fell into the purview of credit risk.

A short-sighted view of the mortgage and credit card market through stress and scenario testing resulted in WaMu not taking into effect the impact of increasingly high defaults, net charge offs, and loan and lease losses.

The failure by regulators to identify and report the presence and dangers of possible default by customers at WaMu, as well as the large proportion of risky assets at WaMu resulted in regulatory and governance risk.

WaMu teaches us that it is easy to fall into the trap of over spending on low quality of assets when credit is easy and interest rates are low. Further, an over dependency on marketing asset backed mortgages is risky, since they are dependent on market sentiments and confidence.

This complete disregard to best practices as well as a myopic view of the market proved fatal for WaMu.