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Preet Bharara and Jenny Durkan Should Read The FDIC Suit Against Officials of Washington Mutual

Preet Bharara

I know Preet Bharara is very busy with his little insider trading cases and his international sting operations, but maybe he could take twenty minutes to read through the FDIC’s complaint against the three top managers of Washington Mutual. Maybe Jenny Durkan, the US Attorney in Seattle, could find the time, even if Bharara is too busy. Here’s the complaint, and here is my discussion of its major elements. When they finish the complaint, they could take a look at the information gathered by Senator Carl Levin and the Permanent Subcommittee on Investigations. Here is Senator Levin’s description of a hearing focused on Washington Mutual:

To date, the Subcommittee hearings have uncovered evidence that, from 2004 to 2007, hundreds of billions of dollars in high risk mortgages flooded U.S. financial markets. Using Washington Mutual (“WaMu”) and its subprime lender, Long Beach Mortgage Company, as a case study, the first hearing showed how lenders targeted high risk borrowers and engaged in risky lending practices such as little or no verification of borrower income, minimal documentation, high loan-to-value ratios, negative amortization, teaser rates, and delayed assessments of higher loan payments that could cause payment shock and increased defaults. That hearing also showed how lenders not only ignored signs of massive loan fraud, but also securitized and sold loans known to contain fraudulent borrower information as well as loans viewed as likely to become delinquent. (my bold.)

In previous posts, I discussed legal theories that can be used to indict the banksters who sold trashy real estate mortgage-backed securities, here, here, and here.

Briefly, the seller of securities is required to disclose the underwriting standards used to make the mortgage loans in the portfolio of the RMBS. It is a crime to fail to make statements necessary to make the statements made not misleading, with the requisite mens rea. The offering materials for the issuance of real estate mortgage-backed securities do not disclose estimates of the number and amount of mortgages that do not meet the standards, even though that information was available, and was material.

The FDIC complaint focuses on the loans retained in the WaMu portfolio. Those loans were a basket of trouble, with enormous losses. But at the same time WaMu was selling loans into securitizations, creating real estate mortgage-backed securities. This was done through its Long Beach Mortgage Company subsidiary, where the RMBSs were sold by Goldman Sachs, among others. Senator Levin’s memorandum discusses the involvement of Goldman Sachs with WaMu in some detail.

WaMu also sold some mortgages it originated into RMBS deals. For example, the offering materials for WMALT Series 2006-AR10, sold in December, 2006, say that Washington Mutual Bank originated about 65.9% of the loans, approximately $328 million. The offering materials describe the due diligence on the mortgages on page S-27, saying that the WaMu credit risk oversight department conducted the due diligence.

The FDIC complaint shows how hollow that assurance is. It says that the risk management people at WaMu repeatedly warned top management about bad lending practices. For example, in 2005 management was told that their models didn’t incorporate “payment shock” (sudden increases in interest rates on existing loans from resets of interest and principal). Their systems were not set up to handle risky loans. They were told that the housing market was “overheated”, a polite term for bubble. They were told they needed to “reduce policy exceptions”, which is apparently their practice of making loans that didn’t meet underwriting standards. They were told that the sales force was overly aggressive.

That stream of information and warnings continued almost until WaMu failed. Upper management was told that the entire risk management operation was inadequate and unsupported. Upper management was repeatedly warned about dangerous lending practices, weak underwriting, lack of adequate controls over origination, and inadequate fraud detection systems. All this is reinforced by information gathered by Senator Levin.

The FDIC complaint makes it perfectly clear that upper management knew that the origination process was in bad shape, and that they continued to push for more loans anyway. This is from a Strategic Direction memorandum from top management in 2006:

“Our plans for the next three years include reducing interest-rate risk and replacing that risk with greater credit risk….” He explained his motivation: “Wall Street appears to assign higher P/Es to companies embracing credit risk and penalizes companies with higher interest-rate and operating risks.”

Neither Bharara nor Durkan is doing anything, and the statute of limitations is running out. Surely there is something to investigate. Surely the FDIC will give them free access to the files of WaMu and help them find the good stuff. Their refusal to investigate must be part of the Great Muddle Through Plan to salvage banksters from both financial and personal responsibility for the Great Crash, and let them get back to business as usual with their reputations and political power intact. And as Doonesbury shows us, their values.

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