The Fall Of Washington Mutual Bank And Its Implications - Case Study Example

The Fall Of Washington Mutual Bank And Its Implications Introduction Washington Mutual, popularly called WaMu was a commercial bank that serviced small businesses and individuals (What Is Washington Mutual? 2009). WaMu continued to be a Northwestern Bank till the 1990’s when the banker began purchasing banks from all over the United States with an initiative to grow through acquisition. The intention of Washington Mutual’s acquisition was to obtain a stronger foothold in the housing mortgage segment of the finance market (Barlas 2009) throughout United States. Almost 60 percent of the business of WaMu was from retail banking. 20 percent came from credit cards, 6 percent from commercial lending and 14 percent from home loans. The sub prime home loans was the major factor that led the bank into trouble and when customers pulled out huge amounts of deposits following fall in share prices, the bank was forced to give into takeover (What Is Washington Mutual? 2009). Thesis: Washington Mutual was the nation’s largest savings bank. It failed because it was reckless with its lending, obsessed with profiteering, and disregarded the use of reasonable lending standards. The WaMu decision makers believed the sub-prime mortgage venture was worth the risk. They believed the blooming housing market would only get bigger, supporting homeowners in a cycle of borrowing against their houses and refinancing later. They were wrong, and when the bottom dropped out, WaMu suffered the consequences and made all those suffer who had fullest faith in its business model and management. The fall of Washington Mutual Washington Mutual was basically renowned for its ability to adapt and to adopt strategies to suit consumer requirements and technological innovations. The bank had survived economic downturns during the 1929 crash because it had amassed assets during flush period. Washington Mutual pioneered the first shared cash machine network in the 1970’s and helped the implementation of Pay-by-Phone banking network. In 1982, after the acquisition of Murphey Favre, the oldest securities brokerage firm in the Northwest, WaMu continued to employ Kerry Killinger, the executive vice president of Murphey Favre. Killinger became the president of WaMu in 1988 and in 1990 he became the CEO. During the leadership of Killinger, the bank faced many problems that include lagging profits and earnings. To tide over the problems, WaMu got out of its regional shell and planned new strategies to ensure growth and stability of the firm. A new kind of banking was introduced by Killinger by servicing middle class customers when several banks was withdrawing from that kind of retail service. WaMu set up branches everywhere without tellers or rope lines with a design that was similar to a department store. In this set up, sales assistants were ready to help in front of computers to conduct transactions. This approach was called ‘occasio’ (Latin) which mean a favorable opportunity. Money was not handled by the tellers; instead, the sales assistants would give a PIN and direct the customer towards machines. The sales assistants were deployed to learn the needs of the customers in terms of financial services. The basic product of WaMu was home mortgage. Killinger’s strategy was to purchase home loan operations and banks that enabled Washingtom Mutual to be rated among the nation’s top banks that serviced mortgages (Washington Mutual Inc.). Reckless lending Washington Mutual was eager to make huge profits during the housing boom and took to frenzied lending process that became one of the main reasons for the credit crunch and the burst of the housing bubble that caused down turn in the economy. It was confessed by the ex-employees confidentially when a lawsuit was failed against WaMu, that the risk managers of the company, who are considered as the gatekeepers to safeguard the bank from undue risks were marginalized, ignored and in certain cases even fired to sanction reckless lending. At the same time, the bank’s underwriters and lenders responsible to make direct sale of mortgages to home owners were pressurized to sell maximum possible number of loans and promote risky lending though lucrative loans to borrowers from all economic stratums. It was disclosed by a former risk managers that the bank ‘took the brakes off the car’. It means the risk managers are like brakes and the brakes were taken away and the company drove over a cliff. This is referred to the acts of the senior management that consciously ignored the early warning from the bank’s risk management team. The advice of the risk managers were ignored while business promoters followed a strategy of reckless and dangerous lending that finally resulted in the fall of the company. As of 2003, Washington Mutual was a good old fashioned banking company that adopted a sensible loan production system and a rigorous risk management procedure. However, the bank took to high risk mortgage lending with the development of the housing bubble because it was lucrative. The company started approving maximum possible number of loans to increase the volume of loans. The efforts to further increase the profits of the company led to an increase in the share of option high risk sub-prime mortgages and option arms or option adjustable rate loans. These loans provided very low introductory rates and allowed borrowers to defer the payment of interest initially, with an option to hold them to pay comparatively higher interest rates in towards the end of the loan period (Thomas & Pearle 2008 p.1). The risk management team of WaMu had prepared a confidential report known as Corporate Risk Oversight Report with a disclosure that the in the long run popular loans such as Option Arms contributed crucial and growing risk aspects because it was an untested method of lending. The report indicates that the executives in the top management of WaMu were put on notice that the company’s risk management system could not even measure or control the extent of extraordinary risk amassed over time with loans like Option Arms. A October 31, 2005 communication from an executive to risk managers at WaMu informed about a cultural change that urged the risk managers to modify the rules of compliance and view risk oversight as a competitive advantage instead of considering it as a regulatory burden. The communication in fact required risk managers to keep quiet even for meaningful issues and hide all negative findings (Thomas & Pearle 2008 p.2). The executives of WaMu are responsible for bringing down the company. Even though the middle management signaled warning at various stages with respect to the incapability of borrowers to pay back, the executives did not heed to any of the suggestions and kept providing loans. The WaMu Option Arm has an interesting slogan that describes it as mortgages that lets the client to control their monthly payments. The Arm borrower can borrow of ‘All Ages’, ‘All Economic Levels’ and ‘Any Social Status’ (Thomas & Pearle 2008 p.3). Obsession for profits With the beginning of the housing market bubble in the United States, Washington Mutual became overly generous in offering mortgages to innumerable customer who were incapable of repaying loans. The then Chief Executive explicitly claimed that WaMu would later be known as the ‘Wal-Mart of Banking’. This aim was to be achieved by the thrift with much disregard for lending standards (Wallop, H. 2008). Lending standards The various alluring loan offers of WaMu were irresistible to cash strapped home owners. Refinancing mortgages at a lesser rate that could reduce payments by half was one of the loan offers. New home buyers were not even required to produce relevant documentation with an added advantage of a very low down payment. Customers who were prey to these offers had a horrible surprise in store. Several Americans were worried over the falling price of homes and borrowers who used the Option ARM loans were in an urgent concern: their repayments were likely to skyrocket. Option ARM was a type of loan created in 1981 and was sold for years to well-financed home buyers who required the option to make low payments for most of the initial months and finally settled the loans with a huge amount. The main objective of the loan was to offer flexibility of payment. But this option was used during the housing boom to attract more buyers because the interest rates were falling. Banks like Washington Mutual were left to adapt to the soaring home prices and therefore they promoted adjustable rate loans that required lower initial payments. The bank used a wide network of unregulated mortgage brokers to maintain the money flow even in risky loans for people with poor financial history to repay the loan and to people with no understanding about the risk. Negative amortization develops in a bank when customers pay only the minimum payment in a month and the remaining amount is added to the balance mortgage. When the balance mortgage reaches a certain amount the interest rates become higher. The underpayment later leads to default on mortgage payment (Nightmare Mortgages 2006). The housing meltdown and credit crunch has had an impact on almost all players in the mortgage market, but the fall of WaMu is mainly attributed to the decision made by its leaders to increase tolerance towards risk and relax lending standards. In the last four years of operation, more than half of the mortgage loans of WaMu were made in the high risk categories with limited documentation and with much disregard for credit history or net worth. These loans are usually called Ninja loans or liar loans because there is no proof for income, assets or job. Investigations from the attorney general of New York and complaints from appraisers indicate that WaMu relied on appraisers to inflate the price of property to support higher mortgages. WaMu relaxed its lending standards not only for customers but also for third party mortgage brokers that allowed brokers with debts to offer more loans. The diversification of WaMu into credit card business with the acquisition of the credit card company Providian Financial in 2005 brought another reason for the downfall. WaMu targeted customers from the sub prime market with weak credit history. When the economy was near recession defaults on credit card repayments were also on the rise. Washington Mutual was the only banker to relax lending standards when the housing boom emerged. The goal of the banking company was to grow. Growth was emphasized over all other factors of its business. The slowdown in the growth turned the bank down to a new segment in the marketplace where they sought customers of lower quality when compared to the normal creditworthy customers the bank usually dealt with. Record-low interest rates on mortgages stimulated a big refinancing boom in the American banking history in which WaMu was a big player. Internal mishaps Though Washington Mutual was among the biggest home lenders in the United States it was hard for the bank to improve profits due to operational missteps that include bungled hedging program, incompatible technologies obtained from various acquisitions and delay in processing mortgage applications (DeSilver, D. 2008). The hedging strategy of WaMu was also under criticism because the rising rates are supposed to increase the value of business to cover hedging costs and earn adequate money to pay the bottom line of the bank. In the case of WaMu, hedging resulted in a loss to the tune of $2.4 billion. The servicing gain was totally wiped out and resulted in a huge loss to mortgage banking also (Tully 2004). The lending standards reached an extraordinary extreme when WaMu bought loans from other banks to pay independent brokers to increase the provision of mortgages on its behalf. Washington Mutual also increased the number of branches and gave loans but could not grow in terms of deposits. The buyers of mortgages experienced deterioration for the housing boom that finally reached a bursting point (DeSilver, D. 2008). Washington Mutual incurred huge loss from sour mortgages. Kerry Killinger was removed as the Chief Executive. After the removal of Killinger, WaMu had announced plans to revamp its operations and forecast its asset quality, earnings and business and capital segment performances without increasing liquidity or raising capital. WaMu shares fell and initially dropped almost 24 percent of its value. Later the shares fell by 90 percent before the erosion in the credit market started. WaMu lost 70 percent market value due to the increase in mortgage defaults and delinquencies and the devaluation of mortgage portfolio. The losses of WaMu mounted and the shares plummeted that sparkled protest from shareholders (Lepro 2008). Washington Mutual had warned that the crisis in sub prime mortgage posed a threat to its operations. The liquidity of the company was expected to be affected with an inability to reach the capital markets or deal with unexpected demands for cash. A normal market disruption was also cited as the reason for the credit crunch which was out of the company’s control. The volatility in sub prime secondary loans had spread into other nonconforming residential loans affecting the liquidity of the company. Sub prime loans were provided to people with poor credit history and the default on these loans caused the turmoil in the financial markets (Washington Mutual warns on sub prime pressures 2007). The beginning of WaMu’s fall WaMu admitted the presence of problems with the announcement that the bank was to lay off thousand employees and was ending many of the sub prime lending. This was followed by another set of job cuts when 2600 positions were curtailed in the home loan section and 550 positions were curtailed in the support and corporate positions. The job cuts and closure of offices were aimed to eliminate around $500 million non-interest expenditures. The company revealed that in the first quarter it expected mortgage losses estimated at $1.8 billion to $2 billion and also informed that losses will continue to be high during the entire year of 2008. The company also revealed plans to gearup funds through public offering and transfer the funds for the operations of Washington Mutual Bank. A report of The Wall Street Journal stated that the portfolio of WaMu had the maximum exposure to risky mortgages when compared to other five leading mortgage lenders. Loans in the high cost section accounted for 29 percent of the total loans that were mostly subprime and 15 percent loans were secured against second homes which is not the primary residence of the owner. Mortgage offered to speculative properties and second homes were considered as more vulnerable to payment default (Setzer, G. 2007). In the beginning of 2008 there were reports that Washington Mutual was aggressively searching for a deal(takeover) to avoid a bailout. Biggest shareholders of WaMu announced their willingness to approve a dilution of stake if the bank was old. This was as a result of heavy losses incurred from adjustable rate loans and the fall of share prices to its lowest levels (Morgan Stanley, WaMu Reportedly Looking For Buyers 2008). The takeover of Washington Mutual was foreseen due to the extent of its exposure to subprime mortgages. The takeover was in waiting when the share prices started sinking (Fleckenstein, B. 2007). Failure The 119 year old Washington Mutual fell when there was persistent instability and the credit of the company was downgraded and when people started withdrawing their money, leaving inadequate cash with the bank to fulfill its obligations. The bank filed for bankruptcy protection as per Chapter 11 and was sold to JP Morgan Chase & Co (Feds investigate Washington Mutual failure 2008). WaMu grew from a nominal thrift to a leading player in the national level in the mortgage segment and finally collapsed due to the housing boom and related miscalculation and mismanagement (Palmeri 2008). It may be concluded that the top management was too aggressive to make profits during the housing book and did not envisage the risks associated with lending to customers with poor credit history. The default in repayment of mortgage from the sub prime market is the main reason that pulled the bank down. Reference Barlas, D. 2009 Washington Mutual Available: http://homebuying.about.com/lw/Business-Finance/Real-estate/Washington-Mutual.htm. Retrieved on December 16, 2009 DeSilver, D. 2008 Where Washington Mutual Went Wrong Available: http://relistr.com/real-estate/where-washington-mutual-went-wrong.html. Retrieved on December 16, 2009 Feds investigate Washington Mutual failure 2008 Available: http://www.msnbc.msn.com/id/27215725/. Retrieved on December 16, 2009 Fleckenstein, B. 2007 Subprime housing game is over Available: http://articles.moneycentral.msn.com/Investing/ContrarianChronicles/SubprimeHousingGameIsOver.aspx. Retrieved on December 16, 2009 Lepro, S. 2008 Washington Mutual removes CEO Kerry Killinger Available: http://www.usatoday.com/money/economy/2008-09-08-3382390904_x.htm. Retrieved on December 16, 2009 Morgan Stanley, WaMu Reportedly Looking For Buyers September 18th, 2008 Available: http://www.subprimelosses.com/blog/index.php/category/firms-under-investigation/washington-mutual/. Retrieved on December 16, 2009 Nightmare Mortgages 2006 Available: http://www.businessweek.com/magazine/content/06_37/b4000001.htm. Retrieved on December 16, 2009 Palmeri, C. 2008 Is Washington Mutual the next to fall? Available: http://www.msnbc.msn.com/id/26744628/. Retrieved on December 16, 2009 Setzer, G. 2007 Washington Mutual Announces Major Layoffs and Closings Available: http://www.mortgagenewsdaily.com/12112007_WaMu_Layoffs.asp. Retrieved on December 16, 2009 Thomas, P. & Pearle, L. 2008 Exclusive: WaMu Insiders Claim Execs Ignored Warnings, Encouraged Reckless Lending Available: http://abcnews.go.com/TheLaw/story?id=6021608&page=1. Retrieved on December 16, 2009 Tully, S. 2004 What Went Wrong at WaMu Washington Mutual built itself into America's biggest mortgage bank almost overnight. But this year, POW! Profits are getting hammered, and the CEO is apologizing to Wall Street. Available: http://money.cnn.com/magazines/fortune/fortune_archive/2004/08/09/377915/index.htm. Retrieved on December 16, 2009 Wallop, H. 2008 Washington Mutual becomes biggest victim of credit crisis Available: http://www.telegraph.co.uk/finance/financetopics/financialcrisis/3087076/Washington-Mutual-becomes-biggest-victim-of-credit-crisis.html. Retrieved on December 16, 2009 Washington Mutual Inc. Available: http://topics.nytimes.com/topics/news/business/companies/washington_mutual_inc/index.html. Retrieved on December 16, 2009 Washington Mutual warns on subprime pressures 2007 Available: http://www.rawstory.com/news/afp/Washington_Mutual_warns_on_subprime_08102007.html. Retrieved on December 16, 2009 What Is Washington Mutual? 2009 Available: http://useconomy.about.com/od/businesses/p/wamu.htm. Retrieved on December 16, 2009 Read More