High-risk lending by the mortgage finance industry sparked the subprime time bomb that undid some of the largest financial institutions, according to statements by a Senate panel today. The Senate Permanent Subcommittee on Investigations, in its first day of hearings this week on “Wall Street and the financial crisis,” grilled former Washington Mutual staffers over the role of high-risk and subprime loans in the bank’s ultimate failure. But the witnesses at the hearing testified a combination of investor demand, competition among originators and securitizers, and a lack of proactive intervention by financial industry regulators aggravated the risk-prone system. Randy Melby, former WaMu general auditor, noted the consolidation of affiliate Long Beach Mortgage Company (LBMC) with WaMu’s Home Loans Group in late 2005 exposed the bank to significant loan risk associated with subprime lending. “Internal audit results reflected a less than satisfactory control environment due primarily to a lack of sustainable and repeatable processes caused by a manually intensive processing environment, non-compliance with policies and standards and an inordinate amount of change,” he said in prepared remarks (download here). Exhibits provided by the Subcommittee said WaMu created “a mortgage time bomb,” in part through practices like high-risk and “shoddy” lending. The memo also noted a “steering” of borrowers into high-risk loans, pollution of the financial system with more than $77bn of securitized subprime loans, securitization of delinquency-prone and fraudulent loans, and “destructive” compensation practices. “The recent financial crisis was not a natural disaster; it was a man-made economic assault,” said Subcommittee chairman Senator Carl Levin (D-MI), in opening statements. “People did it. Extreme greed was the driving force. And it will happen again unless we change the rules.” James Vanasek, former WaMu chief risk officer from 2004 to 2005, told the subcommittee the “pure profitability” of subprime mortgage lending spurred the practice of lax underwriting. He noted WaMu’s focus on rapid expansion ultimately failed. “The focus then shifted away from diversification to becoming the so-called ‘low cost producer’ in the mortgage industry,” Vanasek said, in prepared remarks. “This effort was unsuccessful in large measure due to an expensive undertaking to write a completely new mortgage loan origination and accounting software system that ultimately failed and had to be written off.” He noted gradual risk layering due to incremental changes in mortgage products offered were not fully comprehended until home price declines across the US. Additionally, public policy demanded loans be made to low-income families, and investor appetite swelled for structured products collateralized with those loans. Ronald Cathcart, former WaMu chief risk officer from 2006 to 2008, told the Subcommittee that, as the subprime pain began to mount, WaMu’s regulators seemed ready to allow the bank to work through its own issues. “The banking industry began to move away from the traditional model of ‘originate to hold’ towards a new system of banks as conduits,” Cathcart said in prepared remarks (download here). “Notably, the ease with which securitized mortgage products could be sold encouraged poor underwriting, and guidelines which had been established to mitigate and control risk were often ignored.” Write to Diana Golobay.
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