What Caused WaMu's Collapse?

The Great Financial Crisis caused failures of 25 U.S. banks in 2008. One of the most agreed catalysts for the crisis was the predatory subprime lending practices. As the housing bubble burst in 2008, waves of subprime mortgage payment defaults caused widespread financial distress, eventually leading to the Great Financial Crisis. Washington Mutual (WaMu), one of the nation’s largest savings and loan associations, became the largest bank failure in the U.S. history. Reflecting on the events, WaMu’s collapse highlights the need for ethical conduct and prudent risk management because greed encourages irrational risk-taking behaviors.

WaMu was founded in 1889 in Seattle, initially focusing on providing savings and loan services to local communities. In its earlier days, WaMu operated as “the bank for everyday people”, providing services to support small-to-medium-sized businesses, practicing conservative lending practices for home buyers. With its initial business model, WaMu was reputed as a Main Street bank that emphasized community-oriented banking. However, the profitability of a Main Street bank became uncompelling to satisfy the bank’s growing appetite and the bank started to seek Wall Street profits.

In 1990, Kerry Killinger became the new CEO of WaMu. He had an ambitious plan and outlined his bank as the category killer of retail banking. In his own words, WaMu hoped “to do to [the banking] industry what Wal-Mart did to theirs, Starbucks did to theirs, Costco did to theirs and Lowe’s/Home Depot did to their industry”. He was confident that WaMu would become the Wal-Mart of the banking industry within his five-year plan.

Over the decades, WaMu grew rapidly and became one of the largest thrift institutions in the country. By the end of 2007, WaMu was the largest savings and loan bank with $328 billion in assets, far surpassing World Savings Bank, another large S&L, which had assets of $134 billion in the same year. The key factor behind this phenomenal growth was its aggressive expansion into subprime mortgage lending.

Subprime lending refers to banks issuing loans to individuals considered non-prime borrowers, ranging from those with credit scores below a certain threshold to “Ninjas” (No Income, No Job, No Asset borrowers). Banks package these subprime mortgages into Mortgage-Backed Securities (MBS) and Collateralized Debt Obligations (CDOs), selling them to investors. Similar to High-Yield bonds, subprime securitizations enable high yields because banks charge borrowers higher interests due to their higher probability of default. However, the term “subprime” is positively framed to exploit human cognitive bias, consequently misleading the risks associated with its securitizations. In reality, subprime securitizations are similar to High-Yield Bonds, also known as junk bonds.

Historically, non-subprime borrowers had a low default rate. The high interest rates on these subprime loans generated high cash flows, making the subprime securitizations highly profitable for the banks. In the worst-case scenario, banks could claim the properties to recover the default as long as home values appreciate. WaMu seized the opportunity and quickly expanded into the risky yet lucrative subprime lending market, primarily through multiple acquisitions of subprime lenders.

In 1999, WaMu acquired Long Beach Mortgage, a Los Angeles based S&L, to expand its presents in the subprime market. This acquisition enabled WaMu to diversify its mortgage portfolio, boost its market shares in subprime lending, and gain access to a broader client base. However, the acquisition marked as a pivotal shift for WaMu, as the bank transitioned towards predatory practices from a “Friend of the Family” as it motto stated.

The family-oriented bank began pursuing an aggressive and fraudulent lending strategy. For example, WaMu marketed its signature product, the option ARM, a complex adjustable-rate mortgage. Although the option ARM offered higher interest rates compared to the conventional thirty-year fixed rate loan, the bank enticed borrowers with low minimum payments and a one percent teaser rate. However, the teaser rate expired after the first month and the unpaid interests could quickly accumulate with each minimum payment, likely causing borrowers’ repayments to double or even triple. Subsequently, WaMu issued options for borrowers to cover the minimum payments of these drastically increased bills, exacerbating borrowers’ upward spiral of interest payments.

Instead of verifying the non-prime borrowers’ credit qualifications, WaMu designed a hawkish compensation structure to incentivize its mortgage brokers to take more risks and approve loans as many as possible. The compensation of the loan brokers was primarily commission based, with higher commissions offered for selling riskier loans. These risky loans allowed the bank to charge higher interests, boosting its profits and bolstering the compensation of its executives.

Additionally, WaMu deployed aggressive sales goals and disregarded its unethical and fraudulent sales practices, such as falsifying borrowers’ bank statements, faking their creditworthiness, and persuading borrowers to take loans with the idea of refinancing if they face financial distress in the future. An audit revealed that 83 percent of the loans originated from WaMu’s most profitable branch were fraudulent. The unethical practices facilitated an exponential growth in subprime lending, WaMu securitized $29 billion subprime loans in 2006 compared to $4.5 billion in 2003, representing a more than 600% growth in merely three years.

It is true that borrowers could refinance presuming housing prices were increasing, and subprime market could be lucrative if borrowers did not default. Unfortunately, neither scenario turned out to be reality. The housing market crashed in 2008. In November, home prices declined more than 18% year-over-year in twenty U.S. metropolitans, the largest annual drop since 1987. The continuous decline in home prices triggered waves of defaults. Before 2005, delinquency rates for subprime loans were around 5 percent; in 2008, they drastically rose to 22 percent after the housing bubbles burst.

The value of subprime securitizations plummeted due to the large number of defaults, causing insolvency among banks heavily exposed to the subprime market. The rapid decline in home prices meant that seizing properties could not recover the outstanding loans. WaMu, one of the major subprime lenders, lost more than 95% of its value in 2008. The situation worsened due to a bank run of $16.9 billion over nine days. On September 25, 2008, the FDIC placed WaMu into receivership and later sold it to JPMorgan Chase for $1.9 billion, less than one 1% of its peak asset value.

The collapse of this more than two-century-old bank marked the largest bank failure in the U.S. history. Reflecting on these events, WaMu’s demise was fueled by its own greed. The bank abandoned its community-oriented banking philosophy and conservative lending strategy, becoming a belligerent Wall Street wolf, ruthlessly preying profits via fraudulent conducts, which ultimately led to its own downfall. WaMu’s failure served as a stark lesson that unchecked greed often breeds unethical risk-taking behaviors.