April 14, 2010
Were the big banks all knowingly running Ponzi schemes? That’s the
question that arises from the stunning hearings held this week by the
Senate Permanent Committee on Investigations, chaired by Senator Carl
Levin, on the collapse of Washington Mutual, the largest thrift failure
in the U.S.
Faced with looking like fools or knaves, the barons of the big banks—
from Robert Rubin to Lloyd Blankfein to WaMu’s Kerry Killinger—have
chosen, not surprisingly, the fool. But the WaMu hearings—and Zach Carter’s stunning running commentary on
them—suggest that while Bernie Madoff may have been the extreme, he
wasn’t the exception. (Note: Carter blogs for the Campaign for America’s
Future, which I co-direct.)
The Levin hearings show that WaMu systematically peddled loans to
people it knew could not pay them back. This wasn’t an accident. Levin
exposed a WaMu internal audit that reviewed 132 loans, and found 115
involved confirmed fraud, with 80 having “unreasonable” income—meaning
the income listed on the loan was so preposterous that any reasonable
person, much less a trained loan officer, would have called it into
question. The audit resulted in no—zero, nada—changes in WaMu’s lending
practices. Fraud wasn’t a problem; it was the business plan.
As Carter summarizes:
According to the FBI, 80% of mortgage fraud is committed
by the lender. We’re not talking about stupid loan officers allowing
borrowers to get away with something crazy that is bad for the bank.
We’re talking about clever loan officers pushing fraudulent documents in
order to score bigger paychecks, and bank executives looking the other
way so that they can keep getting big paychecks from the securitization
machine. This isn’t a problem unique to WaMu. This is how the U.S.
mortgage system operated for half a decade.
WaMu particularly pushed predatory option-ARM loans, loans with an
initial monthly payment so low that it often didn’t even pay off the
interest on the loan. Then after a couple of years, the monthly payment
explodes—and the loan becomes unaffordable.
WaMu actively trained its personnel to convince skeptical borrowers
to take these loans because option ARMS received a very high yield when
packaged into securities. So WaMu’s compensation schemes rewarded loan
officers for the number of loans sold, not the quality of the loans.
Stunningly, Levin cited internal memos showing that even loan officers
under investigation for fraud were rewarded with trips to Hawaii and the
Bahamas for their high production.
WaMu packaged the fraudulent loans into securities and sold them to
investors, or peddled the loans to investment banks that did the same.
Even after WaMu’s own internal audits reported that a high percentage of
the loans were fraudulent, WaMu still sold them to investors. Worse,
even after WaMu’s own study showed that the default rates on option ARMS
were going to be staggering, WaMu rushed to peddle even more of these
loans to investors on an “urgent” basis. As Carter reports, “They not
only packaged existing option-ARM loans into securities, they issued as
many new option ARMs as possible, in order to score securitization
profits before the market collapsed.” CEO Kerry Killinger testifies that
he doesn’t know if it would have been appropriate to tell investors
what the company knew about default rates. “I don’t know what actually
happened,” says Killinger.
As Carter summarizes, this was essentially a Ponzi scheme, similar to
Making truckloads of fraudulent loans can only end in
disaster, but WaMu [executives weren’t] really interested in the
long-term picture. They were only interested in their ability to book
these loans for big, short-term profits. Even when those bad loans
finally took the company under, it had been, in a sense, a success. Its
executives had already made millions.
WaMu’s [executives were] in many ways operating a simple Ponzi
scheme. Their risky loans were going bad, but the company was trying to
counter those inevitable losses with the short-term profits from issuing
more risky loans. That’s basically how Bernie Madoff’s scam worked,
except he wasn’t using make-believe loan profits, he was using make
believe stock returns. So long as the bubble keeps growing, the scam
could keep moving. But when the bubble burst, there was no way to keep
issuing lots of loans in an economy where home prices were plunging.
The one divergence from the Ponzi scheme is securitization — if WaMu
could dump the bad loans off its books, then it wouldn’t have to eat
the inevitable losses. But that doesn’t reflect well on WaMu– it means
[the executives] were deceiving and abusing investors.
Why run this scheme that would lead to the ruin of the bank? Because
the executives were making out like, well, like bandits. Killinger, the
CEO of WaMu, was taking home $11 million to $20 million a year during
the housing boom.
As Carter ponts out, what WaMu was doing in mortgages—originating
mortgages that they knew would default, cutting them up into securities,
and marketing them to investors without notice—isn’t much different
than what Goldman Sachs was doing in synthetic subprime CDOs: creating
securities that it knew would fail in order to bet against them, while
selling them to investors without notice.
These guys weren’t fools. They knew what they were doing. They knew
that the music would stop some day, and the reckoning would come, or
more likely, the Feds would step in and bail them out. (Amazingly,
Killinger is still outraged that WaMu wasn’t bailed out rather than put
out of business.) But they kept dancing because they were cleaning up
along the way.
In the last two weeks, the Financial Crisis Inquiry Commission and
the Levin hearings provide a stunning picture of the industry. The good
cop, FCIC, treats the bankers as experts, listens to their opinions,
and lets them claim the role of fools. “We didn’t know.” “We didn’t
realize housing prices wouldn’t always go up”. ” We weren’t
Then yesterday, the bad cop—the Levin committee—exposed the inner
working of what former bank regulator William K. Black calls “control
fraud,” a business model based upon fraud as central to its profitable
operations. It is hard to believe that WaMu or Madoff is an exception.
Levin should probe every major bank engaged in the securitization of
Is it likely that their bank officers were fools? Or that they were
prepared to turn their heads or hold their noses because the rewards
were so great? Ignorance is their defense, not their condition. They
knew what they were doing. The rest is for a prosecutor to sort out.