Washington Mutual Case Study
Five years from 2003, Washington Mutual, Inc.
, the largest U. S’s saving and loan association, lost its standing in the U. S. banking system. It was sold off to JPMorgan Chase on September 25th 2008, which was the biggest failure in the.
This report is based on a case study of Washington Mutual Incorporation, which was once America`s 6th largest saving and loan association. Washington Mutual hoped to be a financial supermarket for retail and commercial consumers. In an attempt to improve slow growth WaMu acquired Long Beach that provided mortgages for people with poor credit history. In 2005 WaMu acquired Providian, a lender of credit cards to customers who could be termed subprime.
Providian used a mathematical model, wherein it issued cards to customers who could pay the monthly charges, but not the high rate of interest on the total debt.
In the event of slowing sales, they doled out cards to lower than subprime customers who in normal circumstances would not be eligible for any debt. Providian sold to WaMu after a host of claims of falsely deceiving and overcharging its customers were made against it. WaMu was seeing a slowing of its home loan business and wanted to enter the credit card business, hoping to gather at one stroke Providian’s 9.5 million customers.
WaMu aimed at lowering the cost of funds by using its retail deposit base. WaMu continued to see a decline in the mortgage sector.
It saw its traditional sources of revenue such as deposits; loan advancement and fee based services reduce. Its assets were increasingly funded by the market or Federal home rates. 20% against the prescribed 15% were funded in this manner. In 2008 WaMu reported losses in April of $12 billion to $19 billion and that 2008 should be the “peak year” for provisioning. Firm-wide net charge-offs totaled $2.2 billion in the second quarter.
Nonperforming assets totaled 3.2% of total assets compared with 2.87% at the end of the first quarter, the bank said. However as the housing crisis raged on, WaMu faced a severe credit crunch, borrowing as much as $7 billion from TPG. The bank faced with defaults tried to reduce costs by lowering the number of branches, but its losses on credit cards and mortgages burgeoned.
Rising inflation further increased the losses in its credit card business. After Lehman Brothers collapsed, WaMu depositors started withdrawing money. WaMu was being pressurized by the Fed Reserve and Treasury department to sell its business.The Government then to redeem the massive negative impact the fall of WaMu would have on the economy, brokered a deal with JP Morgan Chase. Its shares were sold for pennies where they were once valued in dollars. A restructured entity was sold to JPMorgan Chase while WaMu filed for bankruptcy. WaMu chose to forget the principles it was built on. It sacrificed its strengths at the altar of fast growth at any cost, bringing to an end a century plus old bank.
The risk factors and the types of risks that hit WaMu included credit, liquidity, market and operational risk.
The key roles in WaMu`s collapse were played by WaMu itself, the regulators and the credit rating agencies. Washington Mutual Inc. Overview of the Case study Washington Mutual, Inc., founded on September 25, 1889, headquarters in Seattle, Washington, United States.
Washington Mutual Inc. was the former owner of Washington Mutual Bank, the United States’ largest saving and loan association . Since the early 1990s, Washington Mutual Bank expanded its retail banking and lending operations organically and through a series of key acquisitions of retail banks and mortgage companies.
The majority of growth resulted from acquisitions between 1996 and 2002. On October 1, 2005, the Bank entered the credit card lending business by acquiring Providian Financial Corporation. These acquisitions enabled Washington Mutual Bank to expand across the country, to build its customer base, and to become the largest savings and loan association in the country.
The Bank had four business segments
- the Retail Banking Group
- the Card Services Group
- the Commercial Group
- the Home Loans Group
Washington Mutual Bank is a leading originator and servicer of both single and multi-family mortgages and a major issuer of credit cards. By mid of September 2008, under the fear of credit crunch and financial crisis of AIG, Fannie Mae, and Freddie Mac, American consumers rushed to withdraw their deposit from Washington Mutual Bank that created a massive deposit outflow with a total of $16.7 billion in eight consecutive days. The incident pushed the company into an extremely critical situation to have enough time to react through increasing the capital, improving the liquidity, or finding equity partner.
Given the Bank’s limited sources of funds and significant negative deposit, government regulatory agency took a quick action to place Washington Mutual Bank under the supervision of Office of Thrift Supervision, and then placed into the receivership of the Federal Deposit Insurance Corporation. Washington Mutual Inc.
with the book value assets of $307 billions was sold to JP Morgan Chase for $1.9 billions and now it operates as a division of JP Morgan Chase. The holding company Washington Mutual, Inc. subsequently filed for Chapter 11 bankruptcy, ending the history of a 120 year-old company. big dreams poor implementation.
What Made Washington Mutual Bank Collapse?
- Mortgage crisis U. S. housing prices were peak in early 2005, downward in 2006, and continued to the lower end pricing. The deflation of housing price made mortgage debt higher than the value of the property, causing many homeowners becomes negative equity. With inflated income stated on the loan applications, loan borrowers faced with the reality that they had never anticipated, they were no longer afforded to pay interest and installment. Defaults rose continuously leading to the country sub-prime mortgage crisis.
In 2006, Washington Mutual Bank slowed down their option ARM lending, but the company begun to hurt by its ill considered loans.
- Changing business strategy Late of 2006, Washington Mutual Bank was actively changing its business strategy to respond to the declining housing and market conditions. The company tightened credit standards, eliminated purchasing subprime mortgage loans, and discontinued underwriting option ARM. Late 2006 and 2007, Washington Mutual Bank began to increase its capital and its reserves through asset shrinkage and the sale of lower-yielding assets. In April 2008, Washington Mutual Bank received $7.0 billion of new capital from the issuance of common stock.
Since December 2007, Washington Mutual Bank infused $6. 5 billion into their financial statements and met the well-capitalized standards through the date of receivership.
- Negative financial outlook – Increasing loss reserves Washington Mutual Bank did a lot of mortgage lending in California and Florida, where both states have had massive foreclosures. In 2007, the company recorded a $67 million loss and shut down its sub-prime lending unit. By the end of June 2008, the company recorded net loss of $6.
1 billion for three quarters and anticipated a potential loss of $19 billion on its single-family residential mortgage portfolio. When the market conditions were deteriorating in the secondary mortgage, Washington Mutual Bank increased loss reserves by about $500 million in September 2008 that was about 30% higher than it had indicated in July of 2008.
- Public’s pressure – The boiler The situations became further deteriorated by mid of September 2008 after the Countrywide reported another worsening of foreclosures and delinquents. Public increased pressure on Washington Mutual Bank’s lingering financial health as the market conditions continued to worsen. Creditors deeply concerned if the financial crisis sunk deeper, how could Washington Mutual Bank thrives to overcome the crisis and survive?
- Massive outflows – Depletion Eventually the tsunami started its power; Washington Mutual Bank cannot stand and Survive in its turbulence. When Lehman filed for bankruptcy protection on September 15th, 2008, Washington Mutual Bank’s customers began heading for the exits.
Over the next 10 days.
- Customers withdrew a total of $16.0 billion in deposits that was about 9% of the thrift’s deposits As of June 30. Such massive outflows depleted the company so quick, caused a sudden cash imbalance, and gave the company limited time to increase capital, improve liquidity, or find an equity partner.
- Receivership Given the Bank’s limited resources of funding and significant deposit outflows, government regulatory agency were highly concerned about Washington Mutual Bank’s stability and safety to continue its businesses and to be able to pay off its obligations and to meet its operating liquidity needs.
Office of Thrift Supervision decided to place Washington Mutual Bank into receivership on September 25, 2008 and sold to JPMorgan Chase.
OTS acted quickly in few days for this important decision to avoid another massive deposit outflows that might pushed another sunk to the weakening U. S. banking systems. The change had no impact on the bank’s depositors or any customers. On the following Friday morning, September 26, 2008, Washington Mutual branches open as usual with normal business transaction, but under the name of a JPMorgan Chase division.
Key Players Contributing to WaMu’s Bankruptcy
- The Role of High Risk Home Loans How Washington Mutual originated and sold hundreds of billions of dollars in high risk loans to Wall Street in return for big fees, polluting the financial system with toxic mortgages.
- The Role of Bank Regulators Feeble oversight by regulators, combined with weak regulatory standards allowed Washington Mutual Bank to engage in high-risk lending practices and the sale of fraudulent mortgages| The Role of Credit Rating Agencies.
- Moody’s and Standard and Poor’s, the two largest credit ratings agencies, rated tens of thousands of residential mortgage-backed securities and CDOs that were based on high-risk home loans.
High Risk Lending Strategy
Washington Mutual’s executives embarked upon a high risk lending strategy and increased sales of high risk home loans to Wall Street, because they projected that high risk home loans, which generally charged higher rates of interest, would be more profitable for the bank than low risk home loans.
From 2003 to 2008, OTS repeatedly identified significant problems with Washington Mutual’s lending practices, risk management, and asset quality, but failed to force adequate corrective action, resulting in the largest bank failure in U. S. history.
Inaccurate Rating Models
From 2004 to2007, Moody’s and Standard ; Poor’s used credit rating models with data that was inadequate to predict how high risk residential mortgages, such as subprime, interest only, and option adjustable rate mortgages, would perform.
Poor Lending Practices
WaMu and its affiliate, Long Beach Mortgage Company used Poor lending practices riddled with credit, compliance, and operational deficiencies to make tens of thousands of high risk home loans that too often contained excessive risk, fraudulent information, or errors.
Poor Lending and Securitization Practices
OTS allowed Washington Mutual and Long Beach Mortgage Company to engage in Poor lending and securitization practices, failing to take actions to stop its origination.
Competitive pressures, including the drive for market share and need to accommodate investment bankers bringing in business, affected the credit ratings issued by Moody’s and Standard ; Poor’s.
Steering Borrowers to High Risk Loans
WaMu and Long Beach too often steered borrowers into home loans they could not afford, allowing and encouraging them to make low initial payments that would be followed by much higher payments, and presumed that rising home prices would enable those borrowers to refinance their loans or sell their homes before the payments shot up.
Unsafe Option ARM Loans
OTS allowed Washington Mutual to originate hundreds of billions of dollars in high risk Option Adjustable Rate Mortgages, knowing that the bank used unsafe and unsound teaser rates, qualified borrowers using unrealistically low loan payments, permitted borrowers to make minimum payments resulting in negatively amortizing loans.
Failure to Re-evaluate
By 2006, Moody’s and Standard ; Poor’s knew their ratings of residential mortgage backed securities and collateralized debt obligations were inaccurate, revised their rating models to produce more accurate ratings, but then failed to use the revised model to re-evaluate and allowed those securities to carry inflated ratings that could mislead investors.
Polluting the Financial System
WaMu and Long Beach securitized over $77 billion in subprime home loans and billions more in other high risk home loans, used Wall Street firms to sell the securities to investors worldwide, and polluted the financial system with mortgage backed securities which later incurred high rates of delinquency and loss.
Short Term Profits Over Long Term Fundamentals
OTS abdicated its responsibility to ensure the long-term safety and soundness of Washington Mutual by concluding that short-term profits obtained by the bank precluded enforcement action to stop the bank’s use of Poor lending and securitization practices and unsafe and unsound loans.
Failure to Factor In Fraud, Laxity, or Housing Bubble
From 2004 to 2008, Moody’s and Standard & Poor’s knew of increased credit risks due to mortgage fraud, lax underwriting standards, and unsustainable housing price appreciation, but failed adequately to incorporate those factors into their credit rating models.
Securitizing Delinquency and Fraudulent Loans
At times, WaMu selected and securitized loans that it had identified as likely to go delinquent, without disclosing its analysis to investors who bought the securities, and also securitized loans tainted by fraudulent information.
Impeding FDIC Oversight
OTS impeded FDIC oversight of Washington Mutual by blocking its access to bank data, refusing to allow it to participate in bank examinations, rejecting requests to review bank loan files, and resisting FDIC recommendations for stronger enforcement action.
Despite record profits from 2004 to 2008, Moody’s and Standard & Poor’s failed to assign sufficient resources to adequately rate new products and test the accuracy of existing ratings.
WaMu’s compensation system rewarded loan officers and loan processors for originating large volumes of high risk loans and paid extra to loan officers who overcharged borrowers or added stiff prepayment penalties .
FDIC, the backup regulator of Washington Mutual, was unable to conduct the analysis it wanted to evaluate the risk posed by the bank to the Deposit Insurance Fund, did not prevail against unreasonable actions taken by OTS to limit its examination authority.
Mass Downgrades Shocked Market
Downgrades by Moody’s of CDOs and downgrades by S;P of over 6,300 RMBS and 1,900 CDOs, shocked financial markets, helped cause collapse of the subprime and damaged holdings of financial firms worldwide, contributing to financial crisis.
The Financial Risks faced and mishandled by WaMu: Washington Mutual Bank’s management stated in its annual report: The Company is exposed to four major categories of risk: credit, liquidity, market, and operational. Those risks existed in Washington Mutual Bank daily practices.
Operational Risk: Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.
The definition includes legal risk, but excludes reputational and strategic risk.
Washington Mutual was especially exposed to a high level of operational risk when the company was too aggressive in its selling plan and massive expansion within a short period. The operational risk that WaMu faced, includes:
- Aggressive selling plan
- Destructive compensations
- Massive expansion within a short period
- Tolerated loans with fraudulent or erroneous borrower information
Failure to enforce compliance with lending standards Credit Risk: Credit risk is the potential that a bank’s borrower or counterparty will fail to meet its obligations in accordance with agreed terms. The nature of the loan business was the credit risk that was accelerated to an extreme risky level at Washington Mutual’s loan factory, underlying poor credit standards, lingering underwriting system and ambitious sales target. Washington Mutual Bank was hit with the negative impact of U.
S. mortgage crisis. The credit risk included:
- Highly risky lending strategies
- Poor Lending Practices
- Steering Borrowers to High Risk Loans
- Excessive loan error and exception rates
- Failure of OTS to enforce corrective actions
- Inaccurate Rating
Models used by CRA’s Market Risk: The risk that movements in market prices will adversely affect the value of on- or off-balance sheet positions. The risk is attributable to movements in interest rates, foreign exchange rates, equity prices or prices of commodities. exchange rates, equity prices or prices of commodities.
In case of WaMu when the outbreak of loan defaults, housing foreclosure spread out national wide for a long period enough, the economic and financial systems became weakening, leading to the U.S financial crisis and causing immense collapses of financial institution and the U.S. banking system. These incidents presented how the market risks affect the businesses and as well as the nation as a whole.
Liquidity Risk: Liquidity is the ability to fund increases in assets and meet obligations as they become due. It is crucial to the ongoing viability of any organization. The clients headed to withdraw their deposits in the situation of weak financial institutions, the massive outflows quickly depleted Washington Mutual Bank’s resources and capital, put the company at a high liquidity risk and forced to bankruptcy.
Suggested Risk Management Techniques; Credit Risk Management Credit risk arises when the investor looks towards incurring a loss when the borrower fails to deliver the payments as promised. There are a wide range of credit risk solutions which will enable to assess and decide whether the credit commitments will be fulfilled or not. With the flow of credit in the financial markets across the globe slowing down from the pace of Ferrari to that of a snail, credit markets still seem unaggressive and heading down towards the deep tunnel.
Figure out the credit exposure To efficiently figure out the credit exposure, the credit risk solutions focus on how the credit risk affects the profits of the company. The risk is identified and the loss probability initiates from the inability of customers to repay the debts or honor nonmonetary commitments on time. This can also include the access to the credit profiles of the customers which is done to assess the probability of the customer to fulfill the credit commitments.
Provision as well as the analysis of credit risk scores
The credit risk solutions also include the provision as well as the analysis of credit risk scores that helps to judge the extent of credit risk that is associated with each customer. This decision as well as the analysis is done on the basis of the credit report of the customer. Thus, at the same time in order to improve the customer management strategy as well as extract more profits, there are many measures in the form of different tools which are adopted to reduce the losses and increase the net revenue.
Then there is loss forecasting which identifies the characteristics of the borrower and then recognize the potential credit risks. All organizations, businesses as well as government entities require a secure as well as dependable credit risk solution so that they can prevent the operating losses. It is an integral part of the profit management system of an organization. So, it must be tackled effectively!
Operational Risk Management
Active role playing by Regulators: In order to strengthen Operational Risk Management, the regulator needs to play an active role and require banks to meet certain minimum criteria within reasonable timelines or face heavy fines. Until this is done, many of the banks that lag behind the industry standards will continue to do so.
The banks should see the development of a robust ORMF as an investment in reputation and future strengthening of their banking brand, the building of customer confidence, and resultantly more business and returns in the long run.
Market Risk Management : The board and senior management should set up a dedicated market risk management function to coordinate and perform daily risk management activities. An effective market risk management function should include: TO PROVIDE ACCURATE DATA An effective market risk management information system should have the capability to produce timely, accurate and reliable reports for the board, senior management, specialized committees, risk-taking units and risk management and control units. These reports should be used to support decision-making at different levels.
CLEAR RESPONSIBILITIES: Management must Have clearly defined responsibilities and authorities , management must be known with their responsibilities so that they can cope with market risk in future.
DIRECT REPORTING There must be such rules set by the management, where they have a direct reporting line to the relevant senior management or any specialized committee set up by the board INDEPENDENT Management must be able to independently deal with any circumstances in future, must be able to take quick decisions according to current market situation. They must be independent from the risk-taking and operational units DIRECT ACCESS TO INFORMATION: Have direct access to information from risk-taking and operational units in order for it to carry out the market risk management and control function. They need the proper information to make judgments about the strategic direction of their banks, to help set risk appetite and to manage risk according to rapidly changing economic or market conditions.
MUST BE COMPETENT Management must be competent to make new policies and to make them implemented . to manage capital market risk across the enterprise.
This may include re-tooling or developing and implementing robust models to measure market, liquidity, and credit risk. Models and tools should be linked with effectively designed governance practices to establish risk appetite, and to monitor, manage, and report risks.
TESTING OF MODELS Valuation models should be appropriately stress tested to provide senior management with confidence that a complete and accurate picture of the firm’s financial position is visible on a daily basis.
RESPONSIVE TO MARKET CONDITIONS To ensure effective response to deteriorating credit and market conditions, firms should allocate risks by business division or function and assign ownership of risk within each business. Linking business-unit management of risks with the enterprise-wide governance which may improve a firm’s ability to respond quickly and effectively to changing market conditions TECHNOLOGICAL SUPPORT.
Banks should establish and maintain a market risk management information system with adequate technological support and processing capacity to effectively measure and report the market risk exposed to the bank. The market risk management system should be operated in a prudent and consistently effective manner. Liquidity Risk Management: Clear and communicable liquidity risk management policies: A banks liquidity risk management policies should be set down clearly and communicated to key decision makers in the bank. The risk management process should make up the following broad minimum requirements.
The risk must be managed within a defined risk management framework
A clear liquidity risk management and funding strategy must be agreed at an executive and non-executive board level
Operating limits to liquidity risk exposures must be set and adhered to
Procedures for liquidity planning under alternative scenarios must be agreed, including crisis situations Some regulatory wisdom In September 2008, the Basel Committee on Banking Supervision revised their document “Principles for Sound Liquidity Risk Management and Supervision”, by providing more guidance on the following.
Liquidity risk tolerance
- Maintaining adequate levels of liquidity
- Allocating liquidity costs, benefits and risks to business
- Identification and measurement of contingent liquidity risks
- Design and use of severe stress test scenarios
- A contingency funding plan
- Intraday liquidity risk and collateral
- Public disclosure in promoting market discipline