Wall Street and the Financial Crisis: Anatomy of a Financial Collapse
WALK-UP MUSIC FOR DAVID SCHNEIDER DAVID SCHNEIDER
WALK-UP MUSIC FOR DAVID SCHNEIDER DAVID SCHNEIDER
Thank you ladies and gentlemen, and welcome to this very special Awards Evening.
Wow, could you feel the energy and excitement tonight out on the Red Carpet?! Talk about star power!
And it was great fun to learn so much more about some of you during the interviews … and at the bar.
But don't worry. I'm told that the age-old tradition here at Washington Mutual is, 'What happens at President's Club stays at President's Club.' And who am I to mess with tradition?
Tonight we are gathered together to pay the highest respects and honors to those who deserve them the most, the President's Club Class of 2005. …
And of course I want to pay special homage to all of you astonishing returning champions of President's Club. You multiple award-winning superstars clearly lead our entire industry as the standard others can only attempt to match. You folks really do make this feel like the academy awards tonight because everywhere I turn I see another star of another box office sensation." 545
¶This 2005 awards ceremony was attended by WaMu loan officers Luis Fragoso and Thomas Ramirez at the same time they were under investigation for fraud. Both were members of the President's Club in 2005 and 2006.
¶When asked about the sales culture at the bank, Mr. Vanasek testified at the hearing that he tried in vain to counter it. He recalled one occasion at an annual management retreat in 2004, in which the bank was promoting a new advertising slogan called, "The Power of Yes":
147"I stood in front of thousands of senior Washington Mutual managers and executives in an annual management retreat in 2004 and countered the senior executive ahead of me on the program who was rallying the troops with the company's advertising line, 'The power of yes.' The implication of that statement was that Washington Mutual would find some way to make a loan. The tag line symbolized the management attitude about mortgage lending more clearly than anything I can tell you.
"Because I believed this sent the wrong message to the loan originators, I felt compelled to counter the prior speaker by saying to the thousands present that the power of yes absolutely needed to be balanced by the wisdom of no. This was highly unusual for a member of the management team to do, especially in such a forum. In fact, it was so far out of the norm for meetings of this type that many considered my statement exceedingly risky from a career perspective." 546
¶The President's Club annual trip was the pinnacle of WaMu awards to its top producing loan consultants. One loan consultant interviewed by the Subcommittee described it as an incredible experience, with first class airfare, daily gifts, lavish food, and top entertainment for both employees and their spouses. 547 It was also an opportunity to meet WaMu's top executives, including Mr. Killinger, Mr. Rotella, and Mr. Schneider. It sent a powerful message about the priority that WaMu placed on loan volume and sales of higher risk loans.
¶(2) Paying for Speed and Volume
¶The Long Beach and Washington Mutual compensation systems encouraged high volumes of risky loans but provided little or no incentive to ensure high quality loans that complied with the bank's credit requirements. WaMu loan officers or their sales associates typically interacted directly with customers interested in obtaining loans. Some also were allowed to accept loans brought to them by third party lenders or mortgage brokers. Long Beach account executives dealt only with third party lenders or mortgage brokers; they did not deal directly with customers. After reaching agreement on a loan, the WaMu or Long Beach loan officers or executives completed the loan application and sent it to a loan processing center where the application was reviewed by an underwriter and, if approved, underwent further processing and brought to a loan closing.
¶Long Beach and Washington Mutual loan officers received more money per loan for originating higher risk loans and for exceeding established loan targets. Loan processing personnel were compensated according to the speed and number of the loans they processed. Loan officers and their sales associates received still more compensation if they charged borrowers higher interest rates or points than required in bank rate sheets specifying loan prices, or included prepayment penalties in the loan agreements. That added compensation created incentives to increase loan profitability, but not loan quality. A 2008 OTS review elaborated:
"[T]he review defines an origination culture focused more heavily on production volume rather than quality. An example of this was a finding that production personnel were allowed to participate in aspects of the income, employment, or asset verification process, a clear conflict of interest. … Prior OTS examinations have raised similar issues
¶April 13,2010 Subcommittee Hearing, at 2. See also 8/29/2006 email from Greg Lippmann, (Deutsche Bank), to Paolo Pellegrini (Paulson & Co.) and others, DBSI_PSI_EMAIL01625848 at 52 ("Since a CDO without a triple-A-rated senior tranche would be unmarketable, their imprimatur is indispensable."); 11/13/2007 email from Ralph Silva (Goldman Sachs), GS MBS-E-010023525, Tri-Lateral Combined Comments Attachment, GS MBS-E-01035693- 715, at 713 ("Investors in subprime related securities, especially higher rated bonds, have historically relied significantly on bond ratings particularly when securities are purchased by structured investing vehicles."); M&T Bank Corporation v. Gemstone CDO VII, Ltd., Index No. 200800764 (N.Y. Sup.), Complaint, (June 16, 2008) at 12. 12/13/2006 Firmwide Risk Committee December 13 Minutes, GS MBS-E-009582963-64. Subcommittee Hearing at 16-17. 547
¶Subcommittee interview of Brian Minkow (2/16/2010).
148including the need to implement incentive compensation programs to place greater emphasis on loan quality."548 6/19/2008 OTS Findings Memorandum, "Loan Fraud Investigation," JPM_WM02448184, Hearing Exhibit 4/13- 25.
¶(a) Long Beach Account Executives
¶Despite the years of internal and external audits that found a lack of internal controls at Long Beach that led to some of the worst rates of loan delinquency in the subprime industry, Long Beach continued to incentivize production volume over sound lending. The Subcommittee obtained a presentation of the Long Beach 2004 Incentive Plan.549 Documents regarding Long Beach compensation, Hearing Exhibit 4/13-59a. The plan outlines four compensation tiers based on volume, creating a system where the largest producers not only make more money by issuing more loans, but rather, as producers climb more of the tiers, they earn a higher rate of commission as well. Tier 1 Long Beach account executives, those who closed 1-6 loans or funded up to $899,000 in loans per month, received 40 basis points (bps) commission for each broker sourced loan.550 Id. The "units" referred to in the document are "loans." Subcommittee interview of Brian Minkow (2/16/2010). By awarding "basis points" the compensation system ensured that the account executives got a percentage of the loan amounts that they successfully issued after receiving loan information from a broker, incentivizing them to maximize the dollar amount of the loans they issued. Some were also paid a per loan fee, incentivizing them to sell as many loans as possible. Tier 2 Long Beach account executives, those who closed 7-12 loans or funded between $900,000 and $2,499,999 in loans per month, received 50 bps commission for each broker sourced loan plus $30 per loan in additional compensation. Tier 3 Long Beach account executives, those who closed 13-26 loans or funded between $2,500,000 and $4,999,999 in loans per month, received 55 bps commission for each broker sourced loan plus $30 additional per loan. Tier 4 Long Beach account executives, those who closed more than 26 loans or funded more than $5,000,000 in loans per month, received 60 bps commission for each broker sourced loan.551 Id.
¶The 2004 Long Beach Incentive Plan also introduced a contingent compensation program called, "Long Term Cash Incentive Program," which provided bonuses tied to the performance of WaMu stock and could be converted to cash over a three-year period. Top producing Long Beach account executives received the Long Term Cash Incentive bonus calculated as a small percentage of overall volume. Like the tier system, as volume increased so did the percentage used to calculate the bonus. Account executives ranked in the top 25% in volume received a five bps bonus on their total production, account executives in the top 15% received a 7.5 bps bonus, and account executives in the top 5% received a 10 bps bonus. These bonuses could add up to tens of thousands, if not hundreds of thousands of dollars.552 Id.
¶In addition, in 2004, the top 40 Long Beach account executives were rewarded with a trip to the President's Club. Long Beach used a point system to calculate the top account executives for this purpose. Three points were awarded for each loan funded for first mortgages, two points were awarded for each purchase loan funded (as opposed to a refinance), and two points were awarded for each $100,000 funded. The point system created a competition that focused primarily on volume. The 2004 incentive plan makes no reference to loan quality.553 Id.
149¶Long Beach regularly made changes to the compensation plan, but the basic volume incentives remained. In the 2007 incentive plan, which took effect after the collapse of the subprime market, the volume requirements were even greater than 2004 requirements. In 2007, the Tier 1 represented 1-9 qualified loans and up to $1,499,999 funded; Tier 2 was 10-13 qualified loans and between $1,500,000 and $2,399,000 funded; Tier 3 was 14-35 qualified loans and between $2,400,000 and $5,999,999 funded; Tier 4 was 36 or more loans and $6,000,000 or more funded.554 Documents regarding Long Beach compensation, Hearing Exhibit 4/13-59b.
¶(b) WaMu Loan Consultants
¶Like Long Beach, at WaMu loan officers were compensated for the volume of loans closed and loan processors were compensated for speed of loan closing rather than a more balanced scorecard of timeliness and loan quality. According to the findings and recommendations from an April 2008 internal investigation into allegations of loan fraud at WaMu:
"A design weakness here is that the loan consultants are allowed to communicate minimal loan requirements and obtain various verification documents from the borrower that [are] need[ed] to prove income, employment and assets. Since the loan consultant is also more intimately familiar with our documentation requirements and approval criteria, the temptation to advise the borrower on means and methods to game the system may occur. Our compensation and reward structure is heavily tilted for these employees toward production of closed loans."555 4/4/2008 WaMu Memorandum of Results, "AIG/UG and OTS Allegation of Loan Frauds Originated by [name redacted]," at 11, Hearing Exhibit 4/13-24.
¶An undated presentation obtained by the Subcommittee entitled, "Home Loans Product Strategy, Strategy and Business Initiatives Update," outlines WaMu's 2007 Home Loans Strategy and shows the decisive role that compensation played, while providing still more evidence of WaMu's efforts to execute its High Risk Lending Strategy:
"2007 Product Strategy Product strategy designed to drive profitability and growth
150-Driving growth in higher margin products (Option ARM, Alt A, Home Equity, Subprime) …
-Recruit and leverage seasoned Option ARM sales force, refresh existing training including top performer peer guidance
-Maintain a compensation structure that supports the high margin product strategy" 556
¶The presentation goes on to explain the Retail Loan Consultant incentive plan: "Incentive Tiers reward high margin products … such as the Option ARM, Non-Prime referrals and Home Equity Loans …. WaMu also provides a 15 bps 'kicker' for selling 3 year prepayment penalties."557 Id.
¶In order to promote high risk, high margin products, WaMu paid its loan consultants more to sell them. WaMu divided its products into four categories: "W," "A," "M," and "U." WaMu paid the highest commissions for "W" category products, and in general, commissions decreased though the other categories. "W" products included new Option ARMs, "Non-prime" referrals, and home equity loans. "A" products included Option ARM refinancings, new hybrid ARMs, new Alt A loans, and new fixed rate loans. Like Long Beach, WaMu also created four compensation tiers with increasing commissions based on volume. The tiers were called: "Bronze," "Silver," "Gold," and "Platinum."558 Id. Even in 2007, WaMu's compensation plan continued to incentivize volume and high risk mortgage products.
¶In 2007, WaMu also adopted a plan to pay "overages," essentially a payment to loan officers who managed to sell mortgages to clients with higher rates of interest than the clients qualified for or were called for in WaMu's daily rate sheets. The plan stated:
"Overages … [give a] Loan Consultant [the] [a]bility to increase compensation [and] [e]nhance compensation/incentive for Sales Management …. Major national competitors have a similar plan in place in the market. "559 12/6/2006 WaMu Home Loan Credit Risk F2F, JPM_WM02583396-98, Hearing Exhibit 4/13-60b (The proposal to pay overages, adopted in 2007, increased compensation for loan officers who sold loans with a higher interest rate or more points than required on WaMu's daily rate sheet.)
¶Under the 2007 plan, if a loan officer sold a loan that charged a higher rate of interest than WaMu would have accepted according to its rate sheet, WaMu would split the additional profit with the loan officer.560 Subcommittee interview of David Schneider (2/17/2010). This compensation practice, often referred to as awarding "yield spread premiums," has been barred by the Dodd-Frank Act implementing financial reforms.561 Section 1403 of the Dodd-Frank Act (prohibiting "steering incentives").
151¶(c) Loan Processors and Quality Assurance Controllers
¶At Long Beach and WaMu, volume incentives were not limited to the sales people. Back office loan processors and quality control personnel were also compensated for volume. While WaMu executives and senior managers told the Subcommittee that quality control was emphasized and considered as part of employee compensation, the back office staff said otherwise.562 Subcommittee interview of Mark Brown (2/19/2010). Mr. Brown, WaMu National Underwriting Director, told the Subcommittee that incentives for loan processors were based on quality standards and monthly volume. Diane Kosch worked as a Quality Assurance Controller in a Long Beach Loan Fulfillment Center (LFC) in Dublin, California, east of San Francisco Bay. She told the Subcommittee that the pressure to keep up with the loan volume was enormous. Each month the LFC would set volume goals, measured in dollar value and the number of loans funded. At the end of each month the pressure to meet those goals intensified. Ms. Kosch said that at month's end, she sometimes worked from 6 a.m. until midnight reviewing loan files. Monthly rallies were held, and prizes were awarded to the underwriters and loan processors who had funded the most loans.563 Subcommittee interview of Diane Kosch (2/18/2010).
¶Documents obtained by the Subcommittee confirm Ms. Kosch's recollections. A September 2004 email sent to all Dublin LFC employees with the subject line, "Daily Productivity – Dublin," by the area manager uses creative formatting to express enthusiasm:
"Less than 1 week and we have a long way to go to hit our 440M! including today, we have 4 days of fundings to end the Quarter with a bang! With all the new UW changes, we will be swamped next month, so don't hold any back!
4 days…..it's time for the mad dash to the finish line! Who is in the running……
Loan Set Up – Phuong is pulling away with another 18 files set up yesterday for 275 MTD! 2nd place is held by Jean with 243…can you catch Phuong? Get ready Set Up – come October, it's going to get a little crazy!
152Underwriting – Michelle did it! She broke the 200 mark with 4 days left to go! Nice job Michelle! 2nd place is held by Andre with 176 for the month! Way to go Andre! Four other UW's had solid performances for the day as well including Mikhail with 15! Jason and Chioke with 11 and June with 10 – The double digit club!"564 9/2004 Long Beach processing center internal email, Hearing Exhibit 4/13-61. In the email, "UW" stands for Underwriting or Underwriter, and "SLC" stands for Senior Loan Coordinator.
¶Ms. Kosch told the Subcommittee that from late 2005 until early 2007, loan volume increased and loan quality remained very poor. She said that just about every loan she reviewed was a stated income loan, sloppy, or appeared potentially fraudulent. Yet she was not given the resources or support to properly review each loan. Ms. Kosch said that she was told by a Quality Control manager that she should spend 15 minutes on each file, which she felt was insufficient. Yet, because Quality Assurance Controllers received a bonus on the basis of the number of loans they reviewed, she said some of her colleagues spent only ten minutes on each file.565 Subcommittee interview of Diane Kosch (2/18/2010).
¶Ms. Kosch found that often, when she tried to stop the approval of a loan that did not meet quality standards, it would be referred to management and approved anyway. She said good Quality Assurance Controllers were treated like "black sheep," and hated because they got in the way of volume bonuses. She said certain brokers were identified as "elite," and the Dublin LFC employees were told to, "take care of them." Ms. Kosch even suspected some underwriters were getting kickbacks, in part, because of the clothes they wore and cars they drove, which she believed would have been unaffordable to even the top back office employees. She reported her suspicions to her supervisor, but she was not aware of any action taken as a result.
¶As it turns out, Ms. Kosch's concerns about fraud were not unfounded. The September 2004 Daily Productivity email also lauds the work of a Senior Loan Coordinator (SLC) named John Ngo:
"SLC – This one is still tight with Sandy holding on to the first place slot! Sandy funded 4 more on Friday for a MTD total of 46! 2nd place is John Ngo with 4 fundings on Friday and 44 MTD – only 2 back!"
¶About a year after this email was sent, the FBI began to question Mr. Ngo about a scheme to buy houses in Stockton, California with fake documents and stolen identities. According to court records, the FBI had uncovered documents that showed Mr. Ngo had received more than $100,000 in payments from a mortgage broker, allegedly bribes to approve bad loans. Mr. Ngo's estranged wife told the FBI that she didn't know how he could afford their $1.4 million home for which he made a down payment of $350,000. At the time, his salary at Long Beach was $54,000.566 "At Top Subprime Mortgage Lender, Policies Were an Invitation to Fraud," Huffington Post Investigative Fund (12/21/2009), http://www.huffingtonpost.com/2009/12/21/at-long-beach-mortgage-a_n_399295.html.
¶Mr. Ngo later pled guilty to perjury and agreed to testify against his Long Beach sales associate, Joel Blanford. Long Beach paid Mr. Blanford more than $1 million in commissions each year from 2003-2005. According to the Department of Justice:
153"NGO admitted in his plea agreement that most of the payments were to ensure that fraudulent loan applications were processed and funded. NGO also admitted he received payments from Long Beach Mortgage sales representatives to push applications through the funding process. He knew many of these applications were fraudulent, and he and
others took steps to 'fix' applications by creating false documents or adding false information to the applications or the loan file."567 6/19/2008 Department of Justice press release, "Federal Authorities Announce Significant Regional Federal Mortgage Fraud Investigations and Prosecutions Coinciding with Nationwide 'Operation Malicious Mortgage' Takedown," http://sacramento.fbi.gov/dojpressrel/pressrel08/sc061908a.htm.
¶(3) WaMu Executive Compensation
¶Questionable compensation practices did not stop in the loan offices, but went all the way to the top of the company. WaMu's CEO received millions of dollars in pay, even when his high risk loan strategy began unraveling, even when the bank began to falter, and even when he was asked to leave his post. From 2003 to 2007, Mr. Killinger was paid between $11 million and $20 million each year in cash, stock, and stock options. In addition, WaMu provided him with four retirement plans, a deferred bonus plan, and a separate deferred compensation plan. In 2008, when he was asked to leave to leave the bank, Mr. Killinger was paid $25 million, including $15 million in severance pay. Altogether, from 2003 to 2008, Washington Mutual paid Mr. Killinger nearly $100 million, on top of multi-million-dollar corporate retirement benefits.568 "Washington Mutual CEO Kerry Killinger: $100 Million in Compensation, 2003-2008," chart prepared by the Subcommittee, Hearing Exhibit 4/13-1h.
¶As WaMu began losing billions of dollars due to the declining value of its loans and mortgage backed securities, top management paid significant attention to ensuring that they would be well compensated despite the crisis. In January 2008, Mr. Killinger sent Mr. Rotella an email with the subject "comp," seeking input on formulating compensation recommendations for the Board of Directors' Human Resources Committee. The email discussed compensation for WaMu's top executives. Mr Killinger wrote: "Our current thinking is to recommend that equity grants be in options this year. … I am considering an additional restricted stock grant which would help a bit on retention and to help offset the low bonus for 2007."569 1/3/2008 email chain between Kerry Killinger and Steve Rotella, JPM_WM01335818, Hearing Exhibit 4/13-65.
¶Mr. Rotella responded that he thought WaMu executives would want more of their bonuses in cash:
154"[T]he feeling people will have about this is tied to the level of pain on the cash bonus side …. Unfortunately more than a few feel that our stock price will not easily recover, that it is highly dependent on housing and credit and they can't influence that at all. This will come on the heels of what will be a terrible fourth qtr, and likely very poor results in the first half along with continued bad news in the environment. So we will have some people thinking, 'this is nice but I don't see the upside in a time frame that works.' Also, as you know folks feel very burned by the way their paper was tied to performance targets that they now see as unrealistic and tied to housing and have a jaundiced view of paper. … People want more certainty now with some leverage, not a high dose of leverage with low cash."570 Id.
¶Mr. Killinger replied: "In short, the success of the comp program is up to you and me. I think we are putting the right economics and opportunities on the table. But we have to convince our folks that they will all make a lot of money by being with WaMu."571 Id.
¶In February 2008, the Human Resources Committee approved a bonus plan for executive officers that tried to shield the executive bonuses from any impact caused by WaMu's mounting mortgage losses. The Committee established a formula consisting of four weighted performance measures, but took steps to exclude mortgage losses. The first performance measure, for example, set a goal for WaMu's 2008 net operating profit, but adjusted the profit calculation to exclude: "(i) loan loss provisions other than related to our credit card business and (ii) expenses related to foreclosed real estate assets."572 2/28/2008 email from David Schneider, "FW: 2008 Leadership Bonus," JPM_WM02446549. The second performance measure set a target limiting WaMu's 2008 noninterest expense, but excluded expenses related to: "(i) business resizing or restructuring and (ii) foreclosed real estate assets."573 Id.
¶WaMu filed its executive compensation plan with the SEC, as required. The exclusion of mortgage related losses and expenses in the plan attracted notice from shareholders and the press. One March 5,2008 SEC Examination Report for Moody's Investor Services Inc., PSI-SEC (Moodys Exam Report)-14-0001- 16, at 4. SEC Examination Report for Standard and Poor's Ratings Services, Inc., PSI-SEC (S&P Exam Report)- 14-0001-24, at 3. For a detailed discussion of these obligations under federal securities laws, see Section (6)(a), below. article entitled, "WaMu Board Shields Executives' Bonuses," reported: "The board of Washington Mutual Inc. has set compensation targets for top executives that will exclude some costs tied to mortgage losses and foreclosures when cash bonuses are calculated this year."574 "WaMu Board Shields Executives' Bonuses," Wall Street Journal (3/5/2008), Hearing Exhibit 4/13-67. WaMu employees circulated the article through company email.575 Id. Investors and analysts raised concerns.
¶Mr. Killinger sought to respond to the controversy in a way that would placate investors without alienating executives. His solution was to eliminate bonuses for the top five executives, and make cash payments to the other executives, without making that fact public. In July, Mr. Killinger emailed Steve Frank, the Chairman of the Board of Directors, with his proposal:
"We would like to have the HR [Human Resources] committee approve excluding the exec com [Executive Committee] from the 2008 bonus and to approve the cash retention grants to the non NEOs [Named Executive Officers]. This would allow me to respond to questions next week regarding the bonus plan on the analyst call. And it would help calm down some of the EC [Executive Committee] members."576 7/16/2008 email from Kerry Killinger, JPM_WM01240144, Hearing Exhibit 4/13-66.
¶In other words, WaMu would announce publicly that none of the Executive Committee members would receive bonuses in 2008, while quietly paying "retention grants" rather than "bonuses" to the next tier of executives. Mr. Frank replied, "Sounds OK to me." Mr. Killinger followed up with the explanation: "We would disclose the exclusion of EC [Executive Committee] members from the bonus plan. There would be no disclosure of the retention cash payments. Option grants would be held off until whenever other comp. actions were done."577 7/16/2008 email from Kerry Killinger, JPM_WM01240144, Hearing Exhibit 4/13-66. At WaMu's annual meeting with shareholders, the Board indicated that it had "reversed" the decision to exclude mortgage losses when calculating executive bonuses and made no mention of the cash retention payments planned for some executives.578 See, e.g., "Shareholders Score at WaMu," Bloomberg BusinessWeek (4/15/2008) ("And perhaps most notable: WaMu reversed a much-criticized decision to leave out the company's mortgage related losses when calculating profits that determine executive bonuses for the year ahead.").
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