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One of the central unanswered questions of the financial crisis is whether bank executives knew fraud was rampant within their mortgage loans.

A Senate committee tomorrow will present evidence that in the case of Washington Mutual Bank, the largest bank failure in history, executives knew about the fraud – and in some cases failed to take much corrective action. By doing nothing, the bank could report higher profits and employees could earn higher bonuses.

So far no criminal charges have been brought against any senior executives as a direct result of the subprime meltdown. And today Sen. Carl Levin, the Michigan Democrat who will chair the hearing, sidestepped questions about whether Washington Mutual executives broke criminal laws.

But Levin’s committee has unearthed documents that show that in 2005, WaMu’s own internal investigation of two top-producing offices making loans in southern California found that fraud was out of control. At one office in Downey, Calif., 58 percent of mortgages were found to be fraudulent. At an office in Montebello, Calif., the rate was even higher: 83 percent.

Yet “no steps were taken to address the problems, and no investors who purchased loans originated by those offices were notified in 2005 of the loan problems,” Levin’s Permanent Subcommittee on Investigations stated in a report released in advance of the hearing. (A summary of the committee’s findings are here)

Some problems persisted two years later. A follow-up internal review of the bank’s Montebello operation, in 2007, still found a fraud rate of 62 percent.

The results of WaMu’s 2005 internal investigation were sent directly to David Schneider, president of Home Loans. Sources close to the committee say Kerry Killinger, Washington Mutual’s president, chief executive officer and chairman at the time, knew about the internal reviews, but may have found out about them later than others.

Examples of fraud found included phony identifications for borrowers, buyers who acted as fronts for real buyers and phony credit histories. An internal report concluded, “Throughout the process, red flags were over-looked, process requirements were waived, and exceptions to policy were granted.”

A report by the Huffington Post Investigative Fund found similar problems, including reports that supervisors approved loans even after staff tried to raise red flags. The story detailed how management practices at Washington Mutual became an invitation for fraud. Within Long Beach Mortgage, former employees described how some sales people taught brokers how to break the rules, including using fake and forged documents.

The committee found evidence in one Long Beach Mortgage office that sales people sometimes cut and pasted borrowers’ names on false bank statements. As a result of shoddy lending practices, Washington Mutual had default rates on loans it sold to Wall Street as high as 57 percent on a subprime security it sold in 2007, the committee found.

Killinger and Schneider, as well as former president and chief operating officer Stephen Rotella, are scheduled to testify tomorrow. They are expected to say that they took steps to try to correct problems with their subprime loans. Killinger is also expected to say that his bank was on the mend and could have survived had regulators not shut it down in the midst of a run on deposit in September 2008.

In September 2008, Washington Mutual assets were sold to JP Morgan Chase for a pittance — $1.9 billion for a $300 billion company. But WaMu had $188 billion in assets and regulators risked wiping out the FDIC’s $45 billion insurance pool it they hadn’t stepped in, a committee aide said.

Levin said Washington Mutual’s failure was caused by greed.

“They decided they would make more profits if they went for the high-risk loans,” Levin said. “We all paid the price.”

In a memo, Levin described Washington Mutual’s story as “emblematic” of practices common to mortgage lenders from 2004 to 2008.

For most of its history, Washington Mutual had a reputation as a conservative Seattle-based thrift. Its homey motto was, “Friend of the Family.”

But as the Huffington Post Investigative Fund and the Seattle Times reported last year, Killinger made a radical shift in business strategy in 2003, when rising interest rates killed the market for plain-vanilla 30-year fixed-rate loans. He decided to forego marginally profitable conventional loans and aggressively sell high-risk exotic loans, such as subprime, home-equity and Option ARM mortgages.

According to a slide given later at a board meeting, WaMu management showed the bank could make nearly eight times the profit on a subprime loan than on a conventional mortgage.

Killinger promoted the so-called “Option ARM” loan to its flagship product, because it was so profitable. This prime loan offered a low teaser rate but most borrowers fell further into debt with each payment, because one option was to pay even less than the interest charge.

A focus group convened by Washington Mutual in 2003 showed that people who had Option ARMs didn’t understand them. The committee found evidence that sales people were trained to convince borrowers that they could simple refinance if they ran into trouble, because housing prices were soaring.

To sell these high-risk loans, Washington Mutual paid huge commissions to mortgage brokers and loan officers. The worst the terms of the loan for the borrower, the better the commission.

Washington Mutual also loosened its lending standards, allowing borrowers who couldn’t repay a loan to get one and offering loans to people with no need to prove their income. These mortgages, common in the industry, were dubbed “liar’s loans.”

WaMu’s worst problems were in its subprime unit, Long Beach Mortgage, which it acquired in 1999.

Long Beach Mortgage had among the worst default rates on loans in the industry, so bad that AIG at one point refused to insure their mortgage-backed securities. In 2003, Washington Mutual halted the sale of Long Beach Mortgage loans to Wall Street in 2003 and sent in a legal team for three months to try to fix problems.

In a 2006 email, Rotello said of the unit, “We are cleaning up a mess.”

Yet sales of subprime mortgages soared in those years. In 2002, Washington Mutual sold $3.6 billion in subprime loans to Wall Street. By 2006, sales hit $29 billion.

Its most popular subprime loans used low “teaser” rates for the first two or three years, but those rates shot up dramatically when the teaser expired. Many borrowers were caught in loans on which they couldn’t make the monthly payment, unless they refinanced into another teaser rate.

By 2007, bank regulators offered a non-binding guidance to stop this practice. When Washington Mutual ran the numbers, according to a March 2007 email, it found that it would lose 33 percent of its business if it went along with the regulators’ guidance.

A committee aide said that the Office of Thrift Supervision allowed Washington Mutual to delay implementing the new rules for a year.

Justice Department sources say they have been investigating Washington Mutual for months. But fraud cases against senior management are difficult to prove.

Evidence to be presented at the hearing will show that Washington Mutual took steps to suggest they were trying to fix problems. But the fixes didn’t work.

As one committee aide said, “If they really intended to clean it up, why couldn’t they get it done?”

People selling the mortgage were getting huge bonuses and free trips to Hawaii for high volume lending. Washington Mutual’s chief risk officer – who was supposed to control risk – had 35 percent of her paid tied to growth and only 25 percent tied to risk management. And Killinger himself made more than $103 million from 2003 to 2008, making $25 million alone the year his bank died.

Levin said a decision will be made after four hearings on Washington Mutual in the next two weeks as to whether to make a criminal referral to the Justice Department.

This story was published by the Huffington Post Investigative Fund, which later became part of the Center for Public Integrity.

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