Friday afternoon, I had to drive to Baltimore Washington International Airport to pick up my 17-year-old son Jim, who was flying in from Ohio. I could tell you a long story here about Jim’s desire to see his dog Samson, who appears to be terminally ill, and maybe dog-lovers would hit the tip-jar in sympathy, but that’s not what this post is about.
While I was driving, I turned the radio to WCSP-FM — 90.1 FM, the C-SPAN station in D.C. — and listened to a Senate subcommittee hearing on the failure of government regulators in the case of Washington Mutual, which went belly-up in 2008. Here’s the Washington Post story about the hearing:
In a testy exchange with senators Friday, the former head of the Office of Thrift Supervision denied that his agency fostered a cozy relationship with Washington Mutual that tempered oversight of the Seattle thrift and ultimately resulted in the largest bank failure in U.S. history.
A year-long Senate probe presented at a hearing Friday concluded that the OTS had identified a pattern of errors, poor risk management and even fraud at Washington Mutual. Yet it took no action to stop the bank from dumping toxic mortgages into the financial system because the bank was a huge moneymaker that paid fees amounting to 15 percent of the agency’s budget, the panel said.
In effect, the OTS was a “watchdog with no bite” that failed to keep an arm’s-length relationship with the bank it regulated, said Carl M. Levin (D-Mich.), chairman of the Governmental Affairs subcommittee on investigations.
You can read the whole thing, but the point is that OTS regulators had identified serious problems at WaMu and warned the bank about the problems, yet took no effective action against WaMu and never publicized their concerns. Meanwhile, because of a turf-war between OTS and FDIC, at a crucial time the latter agency was prevented from gaining important information necessary to assessing the viability of WaMu.
Many people assumed that federal bank regulation ensured nothing like this could happen, but it did in part because WaMu was trying to compete against lenders like Countrywide Mortgage, which weren’t covered by the same regulations. From the FDIC’s Inspector General report:
Option ARMs represented as much as half of all loan originations from 2003 to 2007 and approximately $59 billion, or 47 percent, of the home loans on WaMu’s balance sheet at the end of 2007. WaMu’s Option ARMs provided borrowers with the choice to pay their monthly mortgages in amounts equal to monthly principal and interest, interest-only, or a minimum monthly payment. Borrowers selected the minimum monthly payment option for 56 percent of the Option ARM portfolio in 2005.
The minimum monthly payment was based on an introductory rate, also known as a teaser rate, which was significantly below the market interest rate and was usually in place for only 1 month. After the introductory rate expired, the minimum monthly payment feature introduced two significant risks to WaMu’s portfolio: payment shock and negative amortization. WaMu projected that, on average, payment shock increased monthly mortgage amounts by 60 percent.
At the end of 2007, 84 percent of the total value of Option ARMs on WaMu’s financial statements was negatively amortizing. . . .
What does “negatively amortizing” mean?
Negative amortization occurs when the minimum monthly payments made after the expiration of the teaser rate are insufficient to pay monthly interest cost. Any unpaid interest is added to the principal loan balance thereby increasing the original loan amount.
Which is to say that the home-buyer who made only the minimum payment was actually building up negative equity — his debt to the bank increasing every month. Here’s more from the IG report about WaMu’s operation:
WaMu underwriting policies and practices made what were already inherently high-risk products even riskier. For example, WaMu originated a significant number of loans as “stated income” loans. Stated income loans, sometimes referred to as “low-doc” loans, allow borrowers to simply write in their income on the loan application without providing any supporting documentation. Approximately 90 percent of all of WaMu’s home equity loans, 73 percent of Option ARMs, and 50 percent of subprime loans were “stated income” loans.
WaMu also originated loans with high loan-to-value ratios. Specifically, WaMu held a significant percentage of loans where the loan amount exceeded 80 percent of the underlying property. For example, WaMu’s 2007 financial statements showed that 44 percent of subprime loans, 35 percent of home equity loans,7 and 6 percent of Option ARMs were originated for total loan amounts in excess of 80 percent of the value of the underlying property.
You may ask yourself, “Why on earth would a bank even make loans under such terms?” Two words: Asset value.
That phrase came up several times during Friday’s hearing, but unless you’ve paid attention to what actually happened in the housing bubble, the significance of the phrase “asset value” may not be readily apparent. For many years, lenders were able to get away with making high-risk loans because of the steady upward trend in the housing market.
“Asset value” in a rising market meant that if you loaned $300,000 on a house and the borrower defaulted –hey, no problem! Foreclose on the loan and re-sell the house for $350,000. So it didn’t really matter how shady the borrower might be, as long as the value of the asset kept going up.
When the housing bubble was really cooking — 2003 through 2006 — both the borrowers and the lenders were thinking of the houses as investments. WaMu got into the game just a couple of years before the bubble burst, and engaged in practices that other lenders had been pursuing for years in markets where a seemingly insatiable demand for real estate meant that there was no such thing as a bad real-estate investment. More from the IG report:
Consistent with its initial business strategy, WaMu made most of its residential loans to borrowers in California and Florida, states that suffered above-average home value depreciation [after the bubble burst in 2007]. Additionally, within California, WaMu’s underwriting standards allowed for up to 25 percent of loans to be concentrated in one metropolitan statistical area.
Dubious lending practices had been more common in these “hot” markets, where strong demand and rising prices enabled the practice known as “flipping” — buying an undervalued home with plans for a quick resale — and where soaring values also made possible frequent home-equity refinancing.
All of this, you see, was based on “asset value” in a booming market, including WaMu’s mergers and acquisitions in 2005-2006, when they gobbled up other lenders with assets valued at more than $60 billion. And if the market had continued to boom, there never would have been a problem, as WaMu’s portfolio would have steadily increased in value. Ah, “if” — the biggest two-letter word in the English language. More from the IG report:
After the mortgage market meltdown in mid-2007, the effects of WaMu’s risky products and liberal underwriting began to materialize. In the third quarter of 2007, WaMu was still profitable, but earnings were 73 percent less than the second quarter because of loan losses. In the fourth quarter of 2007 and the first quarter of 2008, WaMu suffered consecutive $1 billion quarterly losses because of loan charge-offs and reserves for future loan losses. . . .
On September 25, 2008, OTS closed WaMu and appointed FDIC as receiver; FDIC contemporaneously sold WaMu to JPMorgan Chase & Co for $1.89 billion.
Whoa! Just two or three years earlier, WaMu had absorbed through mergers and acquisitions four institutions with combined assets of more than $60 billion, and now WaMu was sold for less than $2 billion! And what of the role of government regulators in this disaster? From the IG report:
At over $300 billion in total assets, WaMu was OTS’s largest regulated institution and represented as much as 15 percent of OTS’s total assessment revenue from 2003 to 2008. OTS spent significant resources monitoring and examining WaMu. OTS conducted regular risk assessments and examinations that rated WaMu’s overall performance satisfactory until 2008. Those supervisory efforts also identified the core weaknesses that eventually led to WaMu’s failure – high-risk products, poor underwriting, and weak risk controls. . . .
OTS relied largely on WaMu management to track progress in correcting examiner-identified weaknesses and accepted assurances from WaMu management and its Board of Directors that problems would be resolved. OTS, however, did not adequately ensure that WaMu management corrected those weaknesses. The first time OTS took safety and soundness enforcement action against WaMu was in 2008 after the thrift started to incur significant losses.
In other words, despite OTS identifying “core weaknesses” at WaMu, no enforcement action was taken until things had already started sliding out of control. Why? Because as long as the housing market kept booming and the company was profitable — as it was until the fourth quarter of 2007 — the risk to investors and depositors was strictly hypothetical. The problems identified by OTS regulators were only dangerous in the event of a serious downturn in the real-estate market, something no one had seen in many years and which no one expected until it actually happened.
This is why liberals screaming about the need for more financial regulation are fundamentally wrong. We can generate new regulations designed to prevent a repeat of the WaMu collapse, but those new regulations — like the old regulations — will only be as good as the officials who enforce them. New regulations will inspire new evasion techniques, equally risky new ventures will attract investors with an appetite for lucrative risks, and the next “bubble” boom-and-bust will occur in some as-yet-unsuspected market sector.
Regulation cannot eliminate all risks, and unbounded faith in financial regulation creates a false sense of security — “Hey, what can go wrong? They’ve got federal regulators on the job!” — which actually makes things worse.
Ultimately, the responsibility for avoiding financial risk belongs to the investor. Like your father always warned, if it sounds too good to be true, it probably is. And as the ancient Romans warned in the sign displayed at the public market: Caveat emptor.
