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December 28, 2008


There's a subtlety to this story that I think isn't well captured by the principal-agent model. It's particularly well expressed in the quotation from CEO Kerry Killinger that opens the story:

We hope to do to this industry what Wal-Mart did to theirs, Starbucks did to theirs, Costco did to theirs and Lowe’s-Home Depot did to their industry. And I think if we’ve done our job, five years from now you’re not going to call us a bank.

So far as I know, Killinger honestly meant that. He (and plenty of others) seem to have believed that they were opening up an industry that had, for generations, been restrained by balkanization and blind adherence to traditional operations. Look at his models: Wal-Mart, Starbucks, Costco, Lowe's and Home Depot. Each of those operations transformed a retail market by standardizing products, using their market position to leverage lower costs, branding themselves as consumer-friendly, and then driving competitors out of business. Until the 1980s, retail banking looked a lot like hardware or groceries. Institutions were local, people had life-long relationships with their local branches, and costs were consequently fairly high. WaMu believed that it could lower costs and dominate the market.

Now, in retrospect, the flaws in his thinking aren't terribly hard to find. If I buy too much from Wal-Mart, and my credit-card debt forces me into bankruptcy, Wal-Mart still gets paid. Not true of mortgages. Also, every jar of peanut butter sold by Wal-Mart is exactly the same, and thus easy to standardize and price; every house is different. In sum, mortgages resist commodification. It's the great lesson of the current debacle.

But it's a mistake to think of Killinger as intentionally looting the company. That kind of fraud, committed in manifest bad faith, is relatively easy to detect and deter. What Killinger and his cronies at WaMu did was far more pernicious. It was a blend of willful blindness and delusion, mixed together with a little fraud. They honestly believed that their model was working. They ignored or disregarded evidence to the contrary. They bullied and browbeat anyone who dared to raise questions into submission. I think it only rose to the level of deliberate fraud in the final couple of years, and perhaps not even then.

The problem, in other words, isn't that CEOs and other officials of companies will - left unchecked - simply loot the corporate treasury. (Although that sometimes happens, it's relatively easy to prevent.) The problem is that if you incentivize them to look at the world in a certain way, they will. Killinger had every incentive to think that maximizing volume was the key to success. His bonuses and other compensation were based upon it. He gathered plaudits from analysts and board members. He was encouraged to switch regulators, from OCC to OTS, because the folks at OTS wanted his volume. So he constructed a warped view of the world in which everyone else was overly pessimistic, and he would build a banking behemoth by seeing what the rest were too blind to perceive. That is, in fact, precisely how successful revolutionary businessmen see themselves. The only difference is that Killinger was very, very wrong.

I'm not trying to let him off the hook. Because he was wrong, he had to take increasingly drastic steps to hold reality at bay. If he'd listened to his honest subordinates back at the beginning of the decade, he never would have waded so deeply into Option ARMs and other toxic products. But he didn't.

I am, however, trying to suggest that simply controlling for outright fraud is insufficient to stop this sort of disaster. There are other, more pertinent, solutions. For one thing, we might want to recalibrate the balance of rewards for corporate executives. If we reward them for growth without regard to its quality, we effectively punish them for prudence. A CEO whose company's revenues rise in pace with inflation will lose his job, even if the company remains profitable decade after decade. That's insane. And it's where our focus properly belongs.

"The bank set up what insiders described as a system of dubious legality that enabled real estate agents to collect fees of more than $10,000 for bringing in borrowers, sometimes making the agents more beholden to WaMu than they were to their clients."

A small point of clarification: A Real Estate agent is always working for the seller, never the buyer. It is the seller that pays their commission. Even if you, as a buyer, go to an agent to help you find a home, they are still working for the seller.

ergo: If they got $10,000 from WAMU, it is not as clear a conflict because they are still facillitating the sale.

Or at least so it was in MO in the mid 80's. The laws may be different in other states, and may have changed here since then

"I don’t think the bank would have let us do the program if it was bad."

This is why regulation and oversight is so important. I agree with Cynic that people in business get involved in their primary goal - to make profit, to facilitate transactions, etc. They allow themselves to assume that the wisdom of what they're doing is being controlled by some higher force: their bosses, the legal department, the regulator. Since the higher force is assumed, the higher force has to be effective, because it's human nature for people to justify their day to day behavior, especially if it's profitable.


To argue that the managers of WaMu honestly believed their spiel is to treat them with too much generosity. Such a construct requires that the operators were deluded, that they held a fixed, but false belief that was resistent to reason or confrontation with actual fact. The reality of this however, was something that Mr. Killinger did understand. He and his cohorts were not deluded. They were committing fraud on a massive scale, and they were assisted in their efforts by the ability to securitize their fraud, to pass the inevitable losses on to millions of unsuspecting bond investors. They just didn't think that they would have to give their money back, or go to jail.

WaMu, according to the article, paid the highest fees for the riskiest loans. It grew to be the 6th largest bank by acquisitions. ' A thin file was a good file.' Billions that were invested in WaMu were lost, but Killinger still has his $100 million, and he has not been charged with crimes.

Killinger may not have envisioned that the housing market implosion would trigger the largest financial contraction since the Depression. But that is not delusional, just somewhat shortsighted for a person at the heart of the situation. Very few people foresaw this consequence.

No, I don't think Killinger honestly believed that his marketing strategy was a sound one. I think he only believed that he would be able to keep his money, and that he would not go to prison.

Execution seems to be the appropriate punishment for the WaMu executive staff.


They paid the most for the riskiest loans because those were the most profitable - the most laden with fees, able to adjust to the highest rates.

Here's the thing the Times article manages to obscure. Neither WaMu nor the purchasers expected these loans to be in effect until maturity. They didn't care about the buyers' credit because they expected to profit whether or not the buyers could meet the terms of the loans. The presumption was that after a few years, the loans would reach a branching point: borrowers who had paid on time, increased their incomes in the interim, or improved their credit would be able to refinance on more favorable terms; those who had fallen behind, or were still not sound financially would sell their homes, and repay the loan (and accrued interest and penalties) out of the proceeds. Either way, the loans would be paid off in full, even if the borrowers lied about their incomes or financial situation. WaMu was willing to say "YES" because they had a business model which seemed, to them, to be fail-safe. These loans were rarely in the interest of the borrower, but almost always in the best interest of the lender, at least over the short-term. A lot like the credit-card industry, except that not even bankruptcy could discharge the debt.

In other words, so long as the real estate market continued to function - so long as home values grew even a tiny bit, or at least hardly declined - WaMu would be protected, and its new business lines would remain immensely profitable. The only thing that could spoil the picture would be a catastrophic collapse in the housing market. And such a collapse would be unprecedented - WaMu believed that by nationalizing its operations, it would be insulating itself from risk. Real estate had been, since the Great Depression, a regional and local business. Markets rose and fell, went through booms and busts, but not in tandem, not all at once.

What WaMu missed, perhaps most crucially, was that nationalizing its operations didn't insulate it from risk - rather, the new national housing market nationalized the risk. Also, that WaMu and other lenders created the conditions for a bubble, and a subsequent collapse, through their lending models. In other words, they created the circumstances of their own undoing, but failed to recognize that they had changed the marketplace. Their risk models were built on the old assumptions, but the resulting business model invalidated those assumptions.

It's always easier to offer an explanation like that proffered by the Times: these were bad people, intent on doing bad things, and they were allowed to do so. That squares with our sense of justice and order. But the reality is that these people were more amoral than immoral. They were driven by the pursuit of profit, not larceny. And preventing a recurrence depends more upon curbing the unameliorated pursuit of profit, or leavening it with other values, than with policing fraud.

C,mon Hilzoy, it was the fault of the borrowers, not of WaMu management. Obviously: is WaMu management poor and black?


You are describing shortsightedness, poor planning, not a delusional belief that the present set of facts are other than they seem to be.

WaMu was practising fraud, falsely misstating the facts - relating to creditworthiness - and relying upon the pooling of loans by securitization, to avoid the consequences of their fraud.

They did it to make money, to profit individually in the short term, in the now known to be misguided hope or expectation, or wish, that everything would work out.

What seems to be missing from these stories is shame. The perpetrators only want to know, in advance, that there is a high liklihood that their acts won't result in prison or forfeiture. They wish for good outcomes, but they are not deterred by the prospect that they will be held in contempt by the community if things don't work out.

These people are interested in the main chance.

What actually happened was perverse incentives were put in place that distorted the market.

It works like this:

On the banker/loan originator side, their mothers taught them to do the right thing at all times and to respect their fellow men and women. Soon, however, the bankers/loan originators were eating from the same 50 pound sack of lentils as their fellow men and women were, and that seemed too much like socialism, so carrots and sticks and bonuses and threats were added to the mix which had the downside of incentivizing all of the behavior their mothers' frowned on but had the upside of creating profitability out of lying and cheating.

On the victim side, especially those who did not understand English, and for those who understood English but forgot to bring their bifocals so they could read the extremely small print, they escaped from privation and predation (see Hilzoy's previous post on incest) in Mexico, and came to the United States already lubed up for financial rape, America's biggest export and home-based industry.

It was a perfect convergence.

Plus, I imagine if we looked into the political affiliation of the Ayn Randers working the loan desks, we'd find the sort of folks who would join whichever political party let them stand on one side of the street in the morning yelling out white-trash imprecations against "wetbacks" and then let them stand on the other side of the street unregulated and rip off said "wetbacks" through mortgage fraud, not that they would differentiate between their victims, America being the land of all are created equal unless it means I might have to eat lentils, in which case all bets are off.

Killinger had every incentive to think that maximizing volume was the key to success.

I think it would be more accurate to say that Killinger worked in a context where every incentive motivated him to maximize volume.

So, yeah, it wasn't all just Killinger personally being a pirate and a greedy, lying sack of sh*t.

To achieve that volume, though, he encouraged his people to do things like make loans to a guy claiming a six figure income as a mariachi musician based on a picture of him dressed up like a member of the Baja Marimba band.

So, being a pirate and a greedy, lying sack of sh*t clearly had no particular downside.

An analogy from another industry might be: to achieve a greater profit level, my general contractor built my new addition out of cardboard. Or, my dentist increased the volume of his business by grinding the enamel off of everyone's molars as part of each semi-annual cleaning.

I have no problem saying this guy should go to jail. I doubt he will, and I doubt he'll give up one cent of his pay or bonuses.

What will it take, exactly, to finally drive a stake through the heart of the unregulated financial market zombie? I sure as hell don't know, but I'll bet good money that we're not there yet.

Thanks -

When WaMu went under, I blogged about my experience -- as a responsible borrower -- refinancing my mortgage from these guys. It was clear at the time (2002) that they were running a fraudulent enterprise.

I was still happy to take advantage of the low rates.

Native American tribes lived in the Northwest for 10,000 years developing a culture that is still regarded enviously as a durable model (cf potlatch). Entering the modern era, we were once widely known as the "48th Soviet of Washington". Then we cut down most of the trees, slaughtered the salmon, and produced a glut of radioactive waste the removal of which has defeated the best minds armed with tons of money. Starting in the 70's we branched out into finance:

WPSS bond default
Seafirt Bank bankruptcy
WaMu implosion

This does not strike me as progress.

That WaMu's executives led the institution down the road of fraud and near extortion ("Yes, you can buy this house. We won't take no for an answer.") is no great suprise. CEO overreach is built into the way corporations are chartered and bylaws through which they are governed. These are government sanctioned, and they must be changed.

The most suprising (and destressing) revelation is the extent to which many lower echelon personnel consciously went along with this scam.

I was delighted when WaMu went down. I hated them. My experience was very different from Mr. Rykoff's -- I was refused a mortgage loan at a time when I had an excellent job, when the ratio of debt to tax-assessed value would have been under 50%. The loan officer lied to me about our credit scores. I knew them, because I had checked it out independently, but she told me they were much lower than they really were. I can't imagine why; maybe she just didn't like our looks. Anyway, when they failed, I thought "it couldn't happen to a more deserving bunch." I love knowing they went down for making risky loans, and refused me. I've never defaulted on anything in my entire (very long) life.

But this all happened because Bill Clinton and the Democrats forced banks to lend to poor people, right?

But it's a mistake to think of Killinger as intentionally looting the company.

Even when, after the mortgage business started showing huge losses, he and the other execs decided to exclude those losses from the formula used to calculate their bonuses? Short of seeing him sneak out the back door wearing a black eyemask and carrying a large canvas bag with a dollar sign on it, that's about as close to deliberate looting as I can imagine.

It was pretty obvious that the pushing effort was to increase bonuses and this required the visible sales rather than reality sales.


For this the US taxpayer is now required to support these people?

Golden parachutes and bonuses and all.


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