Out of Control

Yesterday, the U.S. Senate Subcommittee on Investigations conducted hearings to examine the largest bank failure in U.S. history and its role in the 2008 financial crisis.  The failure of Washington Mutual ("WaMu") was largely the result of years of increasing involvement in the mortgage-backed securities market.  Over a four year period, WaMu increased their securitizations of subprime mortgages from about $4.5 billion in 2003 to $29 billion in 2006.  Altogether, from 2000 to 2007, they securitized at least $77 billion in subprime loans.  At the same time, WaMu allowed its lending practices and controls to erode in the pursuit of greater loan production and short-term profits.  Here is a summary of the investigators' findings.

(1)   High Risk Lending Strategy. Washington Mutual (“WaMu”) executives embarked upon a high risk lending strategy and increased sales of high risk home loans to Wall Street, because they projected that high risk home loans, which generally charged higher rates of interest, would be more profitable for the bank than low risk home loans.

(2)   Shoddy Lending Practices. WaMu and its affiliate, Long Beach Mortgage Company (“Long Beach”), used shoddy lending practices riddled with credit, compliance, and operational deficiencies to make tens of thousands of high risk home loans that too often contained excessive risk, fraudulent information, or errors.

(3)   Steering Borrowers to High Risk Loans. WaMu and Long Beach too often steered borrowers into home loans they could not afford, allowing and encouraging them to make low initial payments that would be followed by much higher payments, and presumed that rising home prices would enable those borrowers to refinance their loans or sell their homes before the payments shot up.

(4)   Polluting the Financial System. WaMu and Long Beach securitized over $77 billion in subprime home loans and billions more in other high risk home loans, used Wall Street firms to sell the securities to investors worldwide, and polluted the financial system with mortgage backed securities which later incurred high rates of delinquency and loss.

(5)   Securitizing Delinquency-Prone and Fraudulent Loans. At times, WaMu selected and securitized loans that it had identified as likely to go delinquent, without disclosing its analysis to investors who bought the securities, and also securitized loans tainted by fraudulent information, without notifying purchasers of the fraud that was discovered.

(6)   Destructive Compensation. WaMu’s compensation system rewarded loan officers and loan processors for originating large volumes of high risk loans, paid extra to loan officers who overcharged borrowers or added stiff prepayment penalties, and gave executives millions of dollars even when its high risk lending strategy placed the bank in financial jeopardy.

These findings are not surprising in the aftermath of the financial disaster.  However, without significant oversight and change in the operations of financial institutions, a similar scenario will likely occur in the not too distant future.

Canary in a Coal Mine

During the recent boom in mortgage-backed securities and credit derivatives, many risk managers were hired to serve as the "canary in a coal mine" for financial institutions.   In the past, coal miners would bring a canary with them to work to ensure that they did not die as a result of carbon monoxide poisoning.  If the canary stopped singing and died, then the coal miners knew to evacuate due to the risk of high levels of carbon monoxide gas in the mine.   The problem with the financial institutions was that the canary (i.e. risk manager) stopped singing in many cases.  The miners (i.e. bankers) chose not to pay attention to the canary at their own peril.  

Just this week, the following was published in US Banker magazine.

"There’s a lot of finger pointing going around about what led to the current financial market breakdown, but perhaps the most ridiculous target of blame is the very idea of financial derivatives, as if these products sprang out of the ground like a particularly potent crop of poison ivy while no one was looking. In reality, a lot of people were looking, and a fair number of risk managers were warning, but too many institutions were either ignoring or mis-measuring the risk."

Rather than solely rely in the future on sophisticated models, the magazine suggests that many financial institutions are getting back to basics.  Edward Hida, a risk management expert from Deloitte, is quoted by the magazine as saying that it all begins with:

"a strengthening of governance and monitoring. The chief risk officer “should serve as a central point. Risk management should be a robust process across functions.”

He makes a great point, but the rest of the organization must heed the warnings of the chief risk officer in the future or suffer the same fate as the poor souls at the bottom of the mine.