Inside Job (10 page)

WaMu’s compensation system reflected the rhetoric on Kauai. Loan officers were paid on a volume-based point system geared to loan product priorities. Of the sixteen products in the
schedule, only the very last one was a traditional mortgage. The top priority was an Option-ARM product, one of the most dangerous of recent inventions. Borrowers could defer principal or interest
payments during the first five years of a loan, accumulating unpaid balances that would later be added to principal. The higher principal payments would kick in at the same time as the permanent
interest rate, which was much higher than the initial teaser. WaMu bragged that they were in second place in OptionARMs, and gaining fast on the market leader, Countrywide.

WaMu’s Long Beach subsidiary was the worst. WaMu’s chief operating officer, Steve Rotella, reported to Killinger in the spring of 2006, when the bubble started
to slow down: “Here are the facts: the portfolio (total serviced) is up 46 percent . . . but delinquencies are up 140 percent and foreclosures close to 70 percent. . . . First payment
defaults are way up and the 2005 vintage is way up relative to previous years. It is ugly.”
¹¹
But the problems went far beyond Long Beach. WaMu
sold almost all forms of high-risk loans—80/20 piggyback loans in which a first and a second mortgage covered the purchase price, the down payment, and the settlement costs; subprime loans;
Option-ARMs; and subprime home equity loans. All of those were combined with “stated income” loansloans with no income verification. Half of WaMu’s subprime loans, three-quarters
of its Option-ARMs, and almost all of its home equity loans were stated income. High-risk loans with stated income were used for properties that were obviously being bought for speculation. Nobody
seemed to blink when babysitters claimed executive salaries. To top it off, like most high-risk lenders, WaMu required that income be adequate only against the initial teaser rate, not the far
higher permanent rate.

Two high-production centres in poor sections of Los Angeles were found to have high levels of fraud—of eighty-five loans reviewed at one centre, 58 percent had confirmed fraud; in
forty-eight reviewed at another,
all
were fraudulent. The two managers were deeply involved in the frauds. Both of them, of course, were longtime President’s Club honourees. The frauds
included straw purchasers, forged documents, and the like. An investigation conducted in 2005 was brought to the attention of senior management but never followed up, and the managers continued
their President’s Club run. A high level of fraudulent activities was disclosed in a third centre—mostly production officers forging borrower data—but another investigation went
nowhere. WaMu, of course, never notified investors who had purchased loans from these centres that the documentation was fraudulent.
¹²

Former WaMu employees, who are serving as confidential witnesses in various civil suits, have testified that every originator was required to underwrite nine loans a day, with cash bonuses
beyond that; that
lending standards were changed almost daily; and that loans that combined FICOs
¹
(credit scores) in the 500s (very
low), Option-ARM structures, and high loan-to-value ratios (LTVs) were sometimes treated as prime. A senior underwriter testified that loans she had turned down frequently reappeared as approved by
higher management. Dozens of former employees have testified in the same vein. The New York State attorney general has also sued WaMu for using financial pressure to cause appraisers to inflate
property values.
¹³

Even in 2007 and 2008, Killinger wanted to ramp up high-risk lending. In late 2007 he announced that WaMu was “adding some $20 billion in loans this quarter, increasing its loan portfolio
by about 10 percent.” This at a time when losses on Option-ARMs in its portfolio had jumped from $15 million in 2005 to $777 million in the first half of 2008.
¹⁴
Then the firm collapsed and was sold to JPMorgan Chase. Afterwards, when asked at a Senate hearing why he had adopted a high-risk lending strategy, Killinger blandly answered
that he had done no such thing.
¹⁵

In March 2011 the FDIC sued Killinger and two other senior WaMu executives for $900 million, alleging that they had taken excessive risk for purposes of short-term personal enrichment. In
December 2011 the executives agreed to settlements totalling $64 million. However, all but $400,000 was covered by their insurance; their personal assets remained nearly untouched, and they were
not required to admit any guilt. Earlier in 2011, the US Justice Department had already announced that it was closing its criminal investigation of WaMu, stating “the evidence does not meet
the exacting standards for criminal charges.”
¹⁶

New Century Financial Corporation was founded in 1995 as an independent mortgage lender concentrating on the subprime segment of
the market. It was listed
on the Nasdaq exchange in 1997. Its annual originations had grown to $3.1 billion by 2000, and shot up to $20.8 billion in 2003, making it the second-largest subprime originator. By 2006, its
originations had grown to $51.6 billion. Three-quarters of its loans were purchased by Morgan Stanley and Credit Suisse, who also provided much of its financing.
¹⁷

In early 2007 it announced both that it would restate its earnings from the first three quarters of 2006, previously announced as $276 million, and that for the full year, 2006 would show a
loss. Securitizing banks withdrew their finance lines in March, effectively shutting down the business, and the company filed for bankruptcy in April. The salaries and bonuses of its three senior
officers in 2005 were approximately $1.9 million each, and that same year each of the three cashed out between $13 million and $14 million in vested stock options.
¹⁸

Interestingly, in 2008, a hedge fund manager named David Einhorn became famous for betting against Lehman Brothers, while questioning its finances and conducting a public campaign against it.
Einhorn accused Lehman of deceptive accounting and of maintaining falsely high valuations on its property holdings. Mr Einhorn certainly knew his subject; but he had been considerably less vocal
about mortgagerelated accounting irregularities when he had been a member of New Century’s board of directors throughout the bubble. An examiner later appointed by New Century’s
bankruptcy trustee conducted an extensive investigation of the company and its auditor, KPMG. A 581-page report filed in February 2008 found substantial causes of action against company officers
for “improper and imprudent” business practices and against KPMG for “professional negligence” and “breach of its professional standard of care.”
¹⁹

The report itself provides many examples of on-the-ground practice during the bubble. New Century’s loan-acquisition volume nearly doubled every year from 2000 through 2004, by which time
internal warning sirens were screaming. Here are samples of e-mails to senior management:

An internal memo said:

Despite the sharp deterioration in loan quality, compensation plans stayed firmly focused on volume. In the end, it was sheer sloppiness that pushed New Century into bankruptcy,
well before the full extent of its
loan defaults and fraudulent behaviour became clear. When an auditor discovered that accounting for loan repurchases required restating, it
wiped out profits for 2006. The committee of Wall Street banks that financed New Century (chaired by Morgan Stanley) stopped providing money, and the company was effectively out of
business.
²²

Countrywide, at first glance, was not the typical subprime lender. Founded in 1969 by David Loeb and Angelo Mozilo, it grew to become the nation’s largest and most
profitable mortgage lender. Mozilo was famous for being obsessively hands-on as well as a terrifying boss. For many years the company had a reputation for conservative lending and excellent cost
controls. In 2003
Fortune
extolled it as one of the most successful American companies, with 23,000 percent stock appreciation since 1982.
²³

Mozilo was ambivalent towards the subprime strategy, and sometimes internally warned of its dangers. But in the end some combination of ego, greed, laziness, and perhaps fatigue (he underwent
spinal surgery several times during the bubble) won out over both ethics and caution. As Mozilo approached retirement age in the midst of the bubble, he announced an absurdly ambitious goal for
Countrywide: a 30 percent share of the whole US mortgage market. This required aggressive expansion into the whole spectrum of toxic loan products, which Mozilo pressured Fannie Mae to buy. The
rest he sold to Wall Street, which didn’t have to be pressured at all.

Countrywide also lobbied intensively and used techniques verging on bribery. Mozilo created a special “Friends of Angelo” VIP unit to provide vastly improved customer service and
favourable mortgage terms to dozens of Fannie Mae executives, elected members of the US Congress, congressional staff members, and various prominent people (one recipient was
Tonight Show
host Ed McMahon, who defaulted on his $4.8 million loan).
²⁴
Recipients included House Speaker Nancy Pelosi
and Senator Chris Dodd,
chairman of the Senate Banking Committee, both Democrats, as well as three successive CEOs of Fannie Mae.

By 2006 Countrywide and its practices had become pervasively fraudulent. In September 2005, Countrywide hired a woman named Eileen Foster as First Vice President, Customer Care, in
Countrywide’s Office of the President. In mid-2006 she was promoted to Senior Vice President. Then, on 7 March 2007, she was promoted again—to Senior Vice President for Fraud Risk
Management. In this position she was
supposedly
in charge of Countrywide’s fraud reduction policies and she also directly managed several dozen fraud investigators.

Naively, she began to investigate fraud, and to do something about it. She rapidly uncovered massive frauds, in multiple regional loan offices, perpetrated by loan officers and managers. As
usual in the industry, loan officers were being compensated based on “production” volume regardless of quality, and indeed, as was also common, they were incentivized to produce loans
with the highest possible interest rates and fees. They could only do this at high volume through fraud.

Nearly immediately, Foster and her organization identified a massive organized fraud operation run by Countrywide personnel in the Boston area, including a regional and division
manager.
²⁵
Foster and her unit developed evidence that forced Countrywide to close six of its eight branch offices in Boston and to terminate over forty
employees. Foster and her unit were told about, and developed evidence regarding, a number of other organized frauds and senior loan personnel involved in fraud. In December 2007 Foster started to
warn her management that there was systematic, widespread fraud within Countrywide. Her immediate manager agreed with her.

In December 2011 the TV programme
60 Minutes
ran an excellent two-part report entitled “Prosecuting Wall Street”, exploring the
lack
of criminal prosecution related to
the bubble and crisis. In it, Foster is interviewed on camera by correspondent Steve Kroft. Here are excerpts: