Policies at WaMu's Long Beach Mortgage invited fraud
Washington Mutual's collapse is often blamed on lax lending practices and a slowdown in home prices. Yet records suggest that management practices at WaMu and its subprime lender Long Beach Mortgage may have been largely responsible for the crisis because they enabled fraud to run rampant.
Huffington Post Investigative Fund
Diane Kosch had one of the most thankless jobs in the subprime-lending craze.
Sitting elbow to elbow with colleagues at a conference table in a Northern California office building, Kosch reviewed a huge stack of loans each day at Washington Mutual's Long Beach Mortgage for problems, including evidence of fraud. She was given 15 minutes per file.
However, even after Kosch noticed clues of mortgage fraud — suspicious income, questionable appraisals or missing documents — loans usually were approved anyway.
Senior managers at Long Beach Mortgage aggressively pushed loans through as one of the nation's biggest subprime lenders, whose focus was higher-rate loans for risky borrowers.
As far as the company was concerned, Kosch's quality-assurance team was slowing things down.
"We were basically the black sheep of the company, and we knew it," said Kosch, who once worked at a WaMu loan center in Bellevue.
"Most of the time everything that we wanted to stop the loan for went above our heads to upper management," Kosch said.
Quality-team members became so suspicious, she said, that they started making copies of problem files to protect themselves. Later, Kosch said, they would see that some of the original files were missing pages — though she didn't know who took them out or why.
Bad loans ultimately led to the collapse of Long Beach Mortgage and its owner, Washington Mutual, in the biggest bank failure in U.S. history.
WaMu's collapse in September 2008, and the housing boom and bust generally, often is blamed on an unfortunate mix of lax lending practices and a slowdown in home prices.
Yet, mortgage records, court documents and interviews with former Long Beach employees suggest management practices may have been largely responsible for the crisis because they enabled fraud to run rampant.
In WaMu's headlong rush to grow, it tossed aside tried-and-true tools for identifying risky borrowers and catching fraud in the form of falsified loan applications.
As part of its business plan, Long Beach required little or no documentation from borrowers or allowed alternate forms of documentation that could be faked.
Independent mortgage brokers recruiting new borrowers treated Long Beach policies as an invitation for fraud, former employees said.
"A lot of brokers were forging a lot of that. They were making up pay stubs and presenting that," said Karan Weaver, who, as an underwriter in Long Beach Mortgage's Atlanta office, said she would reject such loans. "We did see falsified pay stubs and tax returns."
It wasn't unusual in the office for account executives pitching questionable loans to offer money or gifts to loan reviewers to overlook deficiencies.
"They'd offer kickbacks of money," said Antoinette Hendryx, a former underwriting and team manager at Long Beach Mortgage in California. "Or, 'I'll buy you a bottle of Dom Pérignon.' It was just crazy."
The former employees say the company encouraged the sales force to churn out as many loans as possible with lavish commissions and bonuses. And it didn't matter if the loans went bad because Long Beach Mortgage bundled them and sold most quickly to investors.
"At a certain point in the mortgage business, it was just all about greed," said Denetra Summerlin, who worked in quality assurance at the Atlanta office. Her warnings usually were overridden and problem loans approved, she said.
"The greed comes from management," Summerlin said. "It wasn't about quality. It was about 'How many loans can we push out?' "
The FBI last year fielded more than 63,000 tips of suspected mortgage fraud, and agents are juggling 2,800 active investigations. Sources within the Justice Department have acknowledged a criminal investigation of senior management at Washington Mutual.
Kosch, an industry veteran, recalls that loans were scrutinized carefully at WaMu in the early 1990s.
But WaMu went on an acquisition spree later that decade. The culture started changing about the time it bought Long Beach Mortgage in 1999, said Lee Lannoye, a former WaMu executive vice president.
Long Beach Mortgage, based in Southern California, had just settled a lawsuit with the Justice Department for $4 million on allegations that it discriminated against African-American borrowers by charging them higher interest rates.
Lannoye opposed acquiring Long Beach because he believed the subprime business had to be predatory to succeed. Lending to borrowers with a history of not paying bills and mismanaging debt was bound to lead to a lot of defaults.
The only way the subprime business could be profitable, Lannoye believed, was to lure in borrowers with decent credit who simply didn't realize they could find a much better deal.
Lannoye said he found little support among his peers on the executive committee, a factor in his decision to retire that year.
But what happened next was the opposite of what Lannoye predicted. Long Beach began loaning to people who really couldn't afford the payments. The bank didn't hold many of these risky mortgages on its books; it sold most in bundles to Wall Street to make a quick profit and protect itself from potential losses.
Lannoye, in charge of lending at WaMu for a while, said it was obvious to any banker that the loans being made were doomed.
For example, Long Beach started offering no-money-down mortgages — actually two loans. One was for 80 percent of a home's value; the other substituted for the traditional 20 percent down payment.
Asking for no down payment from people with a history of bad or no credit breaks all rules of sound lending. Borrowers had little to lose by walking away from such loans.
Asked to explain why a bank would do this, Lannoye said, "I can only say it has to start at the top."
The strategy to dramatically boost sales of subprime loans came directly from WaMu's chief executive officer, Kerry Killinger. He outlined the plan Dec. 9, 2003, speaking to financial analysts in New York.
Earlier that year, interest rates had started rising, sales plunged and WaMu began losing money on its home-lending business.
So Killinger had a new plan. He would let other banks have the barely profitable conventional loans. Instead, WaMu would boost sales of loans with high profit margins, such as subprime mortgages.
The plan seemed to work beautifully. Long Beach sold $29.8 billion in new loans in 2005, up 85 percent from the previous year. Wall Street was snapping up these loans, paying WaMu big premiums. Everyone in the sales chain was raking in money, from senior corporate executives to account executives assigned to regional offices.
Similar strategies at other subprime lenders fed the national boom in risky loans.
But a strategy to lend to people who can't afford the loans works only if many applications are fraudulent, contends William K. Black, a former federal regulator who helped bring prosecutions in the savings-and-loan crisis of the late 1980s.
Black, who now teaches about white-collar crime as a law professor at the University of Missouri, Kansas City, notes that hundreds of S&L executives went to prison for accounting fraud — consciously making bad loans and pretending they were good.
He contends lenders did precisely the same thing in the latest crisis and that this kind of fraud was the main reason for the subprime meltdown.
S&L executives argued they didn't know the loans were doomed from the start, but many juries didn't buy that defense. Black does not buy the claim from lenders in the latest crisis that they didn't know, either.
"Fraud appears to be the dominant driver of the current financial crisis," he said.
By 2003, thanks to historically low interest rates, nearly everyone who could afford a home owned one. There was no way to sell lots of mortgages, especially as interest rates were rising, under responsible lending practices, Black said.
"But if I loan to people that aren't creditworthy, then I can bring in tens of millions of Americans. And now I can grow rapidly and I get to charge them a higher interest rate," Black said. "If a bunch of other folks follow the same strategy ... we add enormously to the demand for housing."
Creating a housing bubble, Black said, covered up the bad loans because banks would persuade borrowers in danger of default to refinance. That made the bubble even bigger.
No one had to jot down a memo telling everybody to approve fraudulent loans, Black said. All managers had to do was reward people for bringing in sales and ostracize those whose job was to assure quality.
At Long Beach, according to Summerlin, quality-assurance employees were paid $45,000 a year and were segregated from the sales team, whose members could make $1 million or more.
Quality-assurance workers were under "a lot of pressure from the executives. It wasn't so much the direct manager," Summerlin said. "It was from the top."
In a brief statement, Killinger said the policies implemented beginning in 2003 were intended to protect WaMu from the impending housing bust.
Troy Gotschall, former president of Long Beach, declined to respond to requests for an interview.
Evidence that something was terribly wrong shows up in the astronomical foreclosure rate at Long Beach.
The federal bank regulator, the Comptroller of the Currency, compiled data on 10 subprime lenders with the highest foreclosure rates in the 10 cities with the most foreclosures on new loans made from 2005 to 2007. Long Beach Mortgage was the worst, with an average 35 percent foreclosure rate.
Defaults in the first few months of a loan are a red flag for fraud, the FBI has said in court documents. By 2006, a stunning number of loans at Long Beach were quickly going into default.
The Huffington Post Investigative Fund analyzed a bundle of mortgages sold to investors, known as Long Beach Mortgage Loan Trust 2006-4. Even before Long Beach sold this bundle of $1.9 billion worth of freshly inked mortgages in April 2006, 1.2 percent of the loans were in default, according to documents filed with the Securities and Exchange Commission.
But the situation was far worse than it would seem because the vast majority of loans were only days old — too new to be 30 days or more past due. With those loans factored out, 16 percent of remaining loans were in default even before they were sold on Wall Street.
Before 2006, roughly 2 percent of subprime mortgages ended up in foreclosure, industry data show. But in the Long Beach Mortgage Loan Trust 2006-4, at least 44 percent of these mortgages ended up in foreclosure, according to an Investigative Fund analysis, with the help of RealtyTrac, a real-estate data company.
"Those numbers are off the chart," said Richard Bitner, a former president of a small subprime lender, Kellner Mortgage Investments, and author of "Confessions of a Subprime Lender." "That's just ludicrously bad."
David Heath began reporting this story as a Seattle Times staff writer. He joined the nonprofit Huffington Post Investigative Fund this fall.