Wednesday, December 31, 2008

How finance capital created the economic crisis and looted school budgets

A two part post:
WaMu’s Failure, Deloitte’s Failure, Market Failure: A Case Study

It all finally came crashing down on September 25, 2008. After one hundred-plus years of stable steady growth and expansion, ten years of aggressive acquisitions and record profits and one tumultuous year of disaster, the US Office of Thrift Supervision seized Washington Mutual Bank from its holding company after banking hours and placed it into Federal Deposit Insurance Corporation receivership. With rumors of its potential demise spreading, depositors withdrew $16.7 billion in 9 days , crippling the company’s liquidity and ability to act as a going concern. JPMorgan subsequently purchased the bank’s assets and deposits for $1.9 billion, less than a third of what was offered earlier in the year (in stock) and turned down by WaMu’s board .
Washington Mutual’s collapse was the largest bank failure in U.S. history; when large banks fail many other stakeholders are affected, and many parties contributed to the problems that brought WaMu down. The class action complaint brought by Bernstein Litowitz Berger & Grossmann LLP on behalf of investors offers a tremendous array of insider testimony and inside information about WaMu’s operations during the period 2005-2008; it is of such high quality, breadth and scope that it will be the primary source for this analysis. Defendants include top WaMu executives, directors, underwriters of securities offerings, and Deloitte Touche Tohmatsu, a Big 4 accounting firm. Deloitte is accused of violating Section 11 of the Securities Act of 1934 by offering unqualified auditor’s reports attesting to the accuracy of financial statements incorporated into securities offerings made in 2006 and 2007.
Deloitte failed WaMu, and WaMu failed the public. Direct investors in Wamu securities and related derivatives lost substantial sums, and have procedural avenues to claim relief from these losses, whatever their worth. The public has yet another high-profile auditing failure, loss of confidence in the market, and no directly effective remedy. It could be useful to examine the lessons from WaMu and Deloitte’s failure: the decisions that brought them to collapse, the warnings ignored, the laws broken, and what this bank failure says about the audit industry.

WaMu’s “Whoo Hoo” Mortgage Business

According to many former employees of WaMu, the culture and focus of the bank began to change in 2005 with the placement of a new senior management regime. Stephen Rotella joined WaMu as president and COO and acted as president of the Home Loans Group until David Schneider took the position in mid-2005. WaMu also appointed a new Chief Enterprise Risk Officer (Ronald Cathcart) and a new Controller (John Woods) at this time . After 2000 and especially after the transition in leadership in 2005 WaMu’s focus became residential lending and related products as a driver of asset accumulation and interest income. In 2006 and 2007 nearly 70% of interest income and 60% of overall average assets were generated by residential real estate loans either originated by WaMu and held or sold or loans and mortgage-backed securities purchased for investment . This was no accident; WaMu’s new management team had very clearly focused on aggressive tactics to capture market share in residential real estate, offering a new 5 year plan in February 2005 intent on “transforming the company's mortgage business and maintaining a leading national position in mortgage lending…” .
WaMu focused sales efforts on subprime lending and nontraditional products such as interest-only, 80/20, Option ARM and adjustable-rate loans. Mortgage lending had undergone something of a sea change since the last downturn in housing ended in the early 1990s. After the dot-com bubble burst in 2000 low interest rates, stagnant real wages, population growth and rapid appreciation made housing an attractive investment sector for quick cash and equity gains. Expanded markets in securitizing and trading of loans meant that a bank like WaMu could be aggressive in originating loans and earning origination fees without having to hold them in-house and take the attendant risks; lenders could securitize the loans and sell them to third parties as quickly as they could procure them. Highly potentially profitable interest-only, teaser, and especially Option ARM loans overtook traditional fixed-rate mortgages in the WaMu portfolio; Option ARMs themselves represented over 50% of WaMu’s portfolio from Q3 2005- Q2 2008 . Option ARM loans allowed the borrower to make a “minimum” payment below the interest due; the difference would negatively amortize into the principal until “recasted” into a new payment structure after hitting a ceiling of 110-125% of origination amount.
Some WaMu employees interviewed for the class action complaint described the residential mortgage operations as “crooked” and “underhanded” . According to numerous witnesses loan salespeople were often unqualified or uninterested in ensuring that borrowers understood the terms of their loans; Confidential Witness 5 believed that “the majority” of Option ARM borrowers did not understand that their rate and payments would go up after the teaser period (Complaint p. 38). Repeatedly in the complaint employees stated that policy dictated from the highest levels encourage aggressive selling, wholesale noncompliance with company underwriting standards, fictitious appraisals, and “tremendous pressure from the sales guys to approve loans” and that, with the involvement of WaMu management, even questionable loans “usually got taken care of one way or another.” (Complaint p. 36).

Underwriting and risk management standards were materially weakened or ignored with increasing fervor during the period beginning in 2005. Confidential Witness 17, a former Senior Vice President of Enterprise Risk Management, “explained that various Risk Reports were delivered to WaMu’s senior management – including at least Defendants Rotella, Cathcart and Casey – during 2006 ‘specifically quantified the fact that the Company was exceeding certain risk parameters as dictated by [WaMu’s] risk guidelines’” (Complaint p. 44). CW 17 said the methodology that was being used to analyze risk was inadequate and that pleas for corrective action “were overruled” (Complaint p. 44). CW 17 and other senior, experienced risk management leaders chose to leave the company during the class period rather than be parties to the policies being directed by top-level executives. A memo issued by the Chief Compliance and Risk Oversight Officer in October 2005 spelled out the new model, in case employees had failed to grasp it: from then forward Risk Management would be a “customer-service, supporting function” rather that imposing a “regulatory burden” on other Company segments (emphasis mine) (Complaint p. 45-46).

Sean Campbell

Part II.
See the report on WAMU here in the Wall Street Journal.
The 'Market' Isn't So Wise After All

This year saw the end of an illusion.

As I read the last tranche of disastrous news stories from this catastrophic year, I found myself thinking back to the old days when it all seemed to work, when everyone agreed what made an economy go and the stock market raced and the commentators and economists and politicians of the world stood as one under the boldly soaring banner of laissez-faire.

In particular, I remembered that quintessential work of market triumphalism, "The Lexus and the Olive Tree," by New York Times columnist Thomas Friedman. It was published in the glorious year 1999, and in those days, it seemed, every cliché was made of gold: the brokerage advertisements were pithy, the small investors were mighty, and the deregulated way was irresistibly becoming the global way.

In one anecdote, Mr. Friedman described a visit to India by a team from Moody's Investor Service, a company that carried the awesome task of determining "who is pursuing sound economics and who is not." This was shortly after India had tested its nuclear weapons, and the idea was that such a traditional bid for power counted for little in this globalized age; what mattered was making political choices of which the market approved, with organizations like Moody's sifting out the hearts of nations before its judgment seat. In the end, Moody's "downgraded India's economy," according to Mr. Friedman, because it disapproved of India's politics.

And who makes sure that Moody's and its competitors downgrade what deserves to be downgraded? In 1999 the obvious answer would have been: the market, with its fantastic self-regulating powers.

But something went wrong on the road to privatopia. If everything is for sale, why shouldn't the guardians put themselves on the block as well? Now we find that the profit motive, unleashed to work its magic within the credit-rating agencies, apparently exposed them to pressure from debt issuers and led them to give high ratings to the mortgage-backed securities that eventually blew the economy to pieces.

And so it has gone with many other shibboleths of the free-market consensus in this tragic year.

For example, it was only a short while ago that simply everyone knew deregulation to be the path to prosperity as well as the distilled essence of human freedom. Today, though, it seems this folly permitted a 100-year flood of fraud. Consider the Office of Thrift Supervision (OTS), the subject of a withering examination in the Washington Post last month. As part of what the Post called the "aggressively deregulatory stance" the OTS adopted toward the savings and loan industry in the years of George W. Bush, it slashed staff, rolled back enforcement, and came to regard the industry it was supposed to oversee as its "customers." Maybe it's only a coincidence that some of the biggest banks -- Washington Mutual and IndyMac -- ever to fail were regulated by that agency, but I doubt it.

Or consider the theory, once possible to proffer with a straight face, that lavishing princely bonuses and stock options on top management was a good idea since they drew executives' interests into happy alignment with those of the shareholders. Instead, CEOs were only too happy to gorge themselves and turn shareholders into bag holders. In the subprime mortgage industry, bankers handed out iffy loans like candy at a parade because such loans meant revenue and, hence, bonuses for executives in the here-and-now. The consequences would be borne down the line by the suckers who bought mortgage-backed securities. And, of course, by the shareholders.

At Washington Mutual, the bank that became most famous for open-handed lending, incentives lined the road to hell. According to the New York Times, realtors received fees from the bank for bringing in clients, mortgage brokers got "handsome commissions for selling the riskiest loans," and the CEO raked in $88 million from 2001 to 2007, before the outrageous risks of the scheme cratered the entire enterprise.

Today we stand at the end of a long historical stretch in which laissez-faire was glorified as gospel and the business community got almost its entire wish list granted by the state. To show its gratitude, the finance industry then stampeded us all over a cliff.

To be sure, some of the preachers of the old-time religion now admit the error of their ways. Especially remarkable is Alan Greenspan's confession of "shocked disbelief" on discovering how reality differed from holy writ.

But by and large the free-market medicine men seem determined to learn nothing from this awful year. Instead they repeat their incantations and retreat deeper into their dogma, generating endless schemes in which government is to blame, all sin originates with the Community Reinvestment Act, and the bailouts for which their own flock is desperately bleating can do nothing but harm.

And they wait for things to return to normal, without realizing that things already have.

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