The FDIC’s WaMu suit

By Felix Salmon
March 17, 2011
complaint against various WaMu officers makes for fascinating reading. I've embedded it below.

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The FDIC complaint against various WaMu officers makes for fascinating reading. I’ve embedded it below.

One thing that jumps out from the complaint is the enormous amount of very clear documentation here that the WaMu officers in question, up to and including Kerry Killinger, not only knew exactly what they were doing all along, but were very clear about it. They embarked upon an explicit strategy of increasing risk, by writing new mortgages, by concentrating on subprime, and by concentrating geographically. They were aware of the downside risks involved, and they went ahead with the strategy regardless. At the same time, they were very dismissive when it came to risk management.

There’s no indication whatsoever that the officers tried to hide what they were doing from their board or their regulators, or that they thought it was in any way wrong or illegal.

If the risks they took paid off, they would have been hailed as heroes, and the FDIC would have no problem with their behavior. There certainly wouldn’t have been a lawsuit like this one, since the FDIC has to show that it suffered damages before it can bring it.

I don’t like the idea of criminalizing failure. Banks by their nature are leveraged institutions which are vulnerable to runs and to declines in their asset values. There’s always a natural tension between managers, who are looking to maximize profits, and regulators, who are looking to minimize risks. But in this case there’s no indication that WaMu’s regulators, including the FDIC, expressed any concern about Killinger’s strategy. If they were OK with it, at the time, it’s easy to see how the executives considered that a green light to go ahead and implement it with gusto.

But at the same time, it’s unconscionable that these guys should be able to get away with what they did just because they did it out in the open, in front of supine regulators. They knew that they were too big to fail; they knew that ultimately WaMu’s liabilities (or at least its deposits) were being backstopped by the US government; and they knew that if they wanted to get their total compensation up into the $100 million range they were just going to have to take enormous risks and gamble with the money they had essentially unlimited access to at the Fed’s discount window.

Bankers have to be held to some kind of standard. And the standard put forward here, by the FDIC, in paragraph 184, seems a reasonable one to me. Indeed, it’s so clear and reasonable that it’s worth quoting in full:

As officers and/or directors, Killinger, Rotella and Schneider owed WaMu a duty of care to carry out their responsibilities by exercising the degree of care, skill and diligence that ordinarily prudent persons in like positions would use under similar circumstances. This duty of care, included, but was not limited to, the following:

a. To adopt such careful, reasonable and prudent policies and procedures, including those related to lending and underwriting, as required to ensure that the Bank did not engage in unsafe and unsound banking practices, and to ensure that the affairs of the Bank were conducted in accordance with these policies and procedures;

b. To communicate to the Bank’s loan officers and underwriters a clear expectation that they must adhere to sound lending policies and credit procedures by establishing a system of checks and balances and by careful monitoring of loan officers’ conduct;

c. To require that sufficiently detailed, current and reliable information be provided upon which they could make prudent decisions, including the use of current technology and internal control procedures to timely identify problems and allow for early remediation;

d. To support and foster WaMu’s internal risk management functions, and ensure adequate funding for these functions for a Bank of WaMu’s size and assets;

e. To develop contingency plans and take other proactive steps to limit or prevent significant financial losses in the held-for-investment single family residential home loans portfolio;

f. To consider and adopt reasonable recommendations from employees of WaMu’s Enterprise Risk Management department for controlling the Bank’s lending risks;

g. To timely acknowledge and adequately respond to changes in economic conditions that create additional risk with respect to certain types of products or transactions;

h. To enforce policies and procedures designed to ensure that loans would not be made based on inadequate or inaccurate information;

i. Upon receiving notice of an unsafe or unsound practice, to make a reasonable investigation thereof and to exercise reasonable business judgment with respect to all facts that a reasonable investigation would have disclosed;

j.   To carefully review reports of examinations and other directives of regulatory agencies, to carry out the instructions and orders contained in those reports, to investigate and cure problems noted therein, and to prevent any repetition of such problems and deficiencies; and

k.   To conduct WaMu’s business in compliance with all applicable state and federal laws and regulations.

To be sure, a lot of this is 20-20 hindsight vision. But at the same time, it’s basic common sense, and highly-paid bank executives should live and breathe this stuff every day. The fact that WaMu’s executives failed to do so was a significant contributor to a global financial crisis for which, to date, no senior executives have been found responsible at all.

This is by no means a cut-and-dried case, and I suspect that the FDIC will be more than willing to settle with the directors’ insurers before trial. The FDIC has always been particularly vindictive when it comes to WaMu, for reasons I don’t pretend to understand — something which comes out in this complaint when they decided to make the executives’ wives named defendants. It would be great, too, if the FDIC admitted it fell down on the job in terms of regulating WaMu in 2005-8.

Still, I’d like to see more of this kind of thing, rather than less. If only because that way it wouldn’t look like WaMu and its executives were being singled out. Where’s the equivalent suit, for instance, against Stan O’Neal?

Update: Here’s Steve Rotella’s response.

FDICsuit

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Comments
15 comments so far

This pretty much follows what I argued in 08. First Cause, Govt. Guarantees Increasing and Regulation Decreasing. Second Cause, Fraud, Negligence, Collusion, Fiduciary Mismanagement.

Also being Refuted:

1. They didn’t know or understand the risk.
2. The Standards weren’t lowered as the risk increased.
3. The Executives wouldn’t bet against themselves ( Ignoring the money they were salting away )

& this is just a partial list.

Posted by DonthelibertDem | Report as abusive

I would make a point here: No one is criminalizing failure.

They are creating a tort from negligence.

Their behavior is exactly the same as a doctor who leaves a sponge in a patient, only the money amounts are larger.

Posted by Matthew_Saroff | Report as abusive

I hope you lose your job over the japan article. That was really heartless of you

Posted by Radelta | Report as abusive

@Radelta,
Yes, everyone who expresses an idea you disagree with should lose their job.

Posted by LadyGodiva | Report as abusive

Radelta,

Did you read the Japan article? Japan doesn’t want the money, and you get more bang for your buck if the charity isn’t “locked in” to using your money on one specific country. What’s heartless about wanting the money to go to a place where it is needed?

Posted by AnonymousChef | Report as abusive

Wow, it’s only March 18 and we already have a strong candidate for comment of the year! Congratulations Radelta, you managed to squeeze an ad hominem, and an implied straw man into one line. All on a completely unrelated article!

Posted by CavelCap | Report as abusive

Ah, never mind. I just glanced over and saw the 208 comments on the actual article. I’m sure those were simply teeming with insight and good sense.

Posted by CavelCap | Report as abusive

An issue that seem to be overlooked is that from 2001 through 2008, the bush* administration was very anti-regulation and frequently put the foxes, industry insiders, in place to regulate their own industries. These insiders obstructed any effective regulatory actions and let the “invisible hand” stuff money in their pockets.

How can a regulator be effective when their boss doesn’t let them?

Posted by Josiah_Bartlett | Report as abusive

“the FDIC has been particularly vindictive when it comes to WaMu…”

Yes, there is a particularly nasty dog-eat-dog history there as the FDIC believes that WaMu should be one of our poster children of regulatory capture.

WaMu’s primary regulator was the OTS, not the FDIC. The FDIC could only get involved once WaMu was rating was downgraded to a CAMEL 3, 4, or 5. Wholly inconsistent with the gross negligence allegations in the FDIC suit and incredible in retrospect, the OTS was rating WaMu a CAMEL 2 in August 2008, one month before failure.

WaMu, given its size, accounted for approximately 13% of the OTS operating revenues. Although John Reich publicly denied any such capture, other evidence points to WaMu having wagged the OTS dog rather forcefully.

When the financial crisis started, the OTS apparently stonewalled the FDIC when it started raising alarms about WaMu’s condition. The OTS stonewalled by not downgrading WaMu’s CAMEL rating below a 2 and thereby effectively kept the FDIC at bay.

And the FDIC is the one now baying at what is left of the dead dog. And indirectly baying at the soon-defunct OTS as well.

Posted by AABender1 | Report as abusive

It is worth noting that the FDIC is not “criminalizing” anything. The have no authority to bring criminal charges and are seeking civil money penalties in the current litigation.

Posted by markclose | Report as abusive

“I don’t like the idea of criminalizing failure. Banks by their nature are leveraged institutions which are vulnerable to runs and to declines in their asset values.”

What I hate even more than “criminalizing failure” is socializing the losses made by very well compensated bankers – excessively huge compensation granted to them for their “risk management” skills.

And what I hate even more than THAT is seeing funding for education and other social services cut throughout the country because the economy outside of Wall Street, tanked, thanks to the poor risk management skills of people paid millions to know better, screwing over the budgets of individuals, families and state and federal government alike…

Posted by MainStreetMuse | Report as abusive

MainStreetMuse, i assume you were also bitching about banks when an artificial credit bubble pumped up the economy for 5 years?

Posted by Danny_Black | Report as abusive

Danny_Black, I don’t know about MSM but I was quite critical of certain practices in finance at the time — and I didn’t even know half the story!

* Compensation is excessive. When compensation in some divisions is half of revenues, and bonus-structured on short-term targets, it encourages stupid risk-taking.

* The lending practices generated huge short-term profits, but practically guaranteed that there would eventually be matching losses. How many years of profits were wiped out in the crash?

But has the economy outside of Wall Street truly tanked? Or is it simply the result of retrenchment in the banking/construction/real-estate businesses? That is a pretty big part of the economy, and activity today is a small fraction of where it was at its peak.

What I don’t understand is how the directors and shareholders allowed the system to develop as it did. The board of directors is SUPPOSED to take a long-term view on behalf of the shareholders. Were they truly doing that?

Posted by TFF | Report as abusive

I’m days late to this post but my color on why the FDIC has so much spite for the WaMu boys is they caught the FDIC’s hand in the cookie jar.

You see unsecured depositors, (those over the FDIC limits) are JUNIOR to senior secured bond holders. The FDIC badly wanted to end runs on the nations banks which at the time of the WaMu takover were beginning to happen in earnest.

They move in and take over a company with a positive value just hours before all the other TBTF banks get saved by the Fed and Treasury.

The WaMu boys correctly called the goverments bluff and still lost the hand because the goverment changed the rules in the middle of the game.

By covering all deposits (including HUNDREDS OF MILLIONS deposits above the FDIC limits) while giving senior secured bond holders losses they insured that the entire shadow banking system would crumble. The FDIC honestly didn’t realize at the time that the shadow banking system was actually larger and more imporntant than the commercial banks they regulated.

After the bid for even high quality financial assets vanished the feds looking into the abyss and saw that the dominos simply would not stop falling on their own. It took TARP, TALF, Zero Interest Rate Policy, QE1&2 to reboot the system.

Stuff of legend… I’ll remember 08/09 for 50 years!

Posted by y2kurtus | Report as abusive

OK, perhaps I’m bit late to this party, but I do have a bit of a problem with the standard. Specifically, this part:

k. To conduct WaMu’s business in compliance with all applicable state and federal laws and regulations.

That is a high standard, and I very much doubt that any organization can reach 100 percent compliance. The rules are too many, they change too often, and there often are many areas within regulation and laws that are less than clear. I’d rather see the establishment of a reasonable compliance program rather than a declaration that one would comply with every conceivable legal standard. No compliance program will achieve perfection. But good ones will circle back when problems are unearthed and make improvements.

Posted by ademangone | Report as abusive
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