How option ARMs killed WaMu

(This is Part 2 of a two-part series. Read Part 1, "WaMu failed to heed lesson learned in '80s.")

Kerry Killinger, the former strategist at the brokerage firm Murphey Favre, became Washington Mutual's chief executive in 1990. He made his first significant money by flipping investment homes in eastern Washington state and deeply believed in the power of the housing industry.

Killinger was all about the business of mortgages and engineered the bank purchases that would make WaMu the nation's largest residential lender. In the end, it was a loan -- "the only loan you'll ever need" -- that brought the bank down along with the customers who yanked their deposits because of the loan's reputation. Killinger was removed as chairman just before the bank was handed over to the Federal Deposit Insurance Corp. and sold off to JP Morgan Chase in the biggest failure in U.S. banking history.

The option adjustable-rate mortgage (ARM) will be the loan that will be blamed for Washington Mutual's demise. The bank believed the loan was a creative mortgage that would help a variety of borrowers in various stages of their lives. The loan gave borrowers more choices over monthly payments each month, thus providing an opportunity to "flip-flop" payments according to household cash flow. Because of its flexibility and versatility, it was promoted as "the only loan you'll ever need."

After the initial start period, customers could select among four payments plans each month during the life of the loan. Borrowers are never locked into one specific payment or amount, leaving open the possibilities of pulling back during a money crunch or shelling out more after an unexpected windfall.

Here were the options in a capsule.

• Minimum payment: This is a very low payment that leaves you more cash during lean months. However, at times the payment amount may not be enough to cover the interest portion of the loan. If so, that amount would be added to your original loan.

• Interest-only payment: The payment still is low, yet you pay only the interest portion and any deferred interest that may have accrued. While you do not reduce the original loan amount, you do not "go backwards" or owe more than you borrowed.

• Regular payment: This is a common, 30-year, fixed-rate loan payment. When you choose this option, you pay all the interest and principal needed to pay off your loan on time.

• Accelerated payment: This schedule would pay off your loan after 15 years. The payment is higher, yet you save substantial interest dollars while gaining equity faster.

Customers got lulled into making minimum payments for far too long, compiling substantially more debt than the original loan amount. Others knowingly used the loan to get into homes they realistically could not afford. More importantly, the bank accepted option ARMs from many brokers who did a rotten job of explaining how the loan really worked.

The option ARM was a microcosm of the WaMu mortgage acquisition spree. The prevailing philosophy had been that brokers and bankers should always "get" what WaMu was offering. It was almost as if Killinger's troops were confounded that mortgage reps -- both in-house and corresponding brokers -- were too slow to grasp the terrific programs the bank was making available to consumers.

For example, while Washington Mutual had offered adjustable-rate mortgages in the past, its bread and butter had been 30-year, fixed-rate loans -- with a 20 percent down payment. American Savings and Great Western, two large lenders acquired in 1996 and 1997, had huge pipelines for ARMs, including the then-hip COFI ARM whose index was the less volatile Cost of Funds Index, or COFI. Killinger and company felt that all of the new mortgage businesses would dovetail nicely under the Washington Mutual umbrella.

By 1998, the stress of bringing WaMu's mortgage strategy to all newcomers was clearly showing. An unnerving number of mortgage payments were lost or misplaced, county property taxes were mishandled, and loan documents arrived late at escrow offices. Efforts were made to improve service, but the anticipated seamless merges did not happen.

Kerry Killinger clearly understood how mortgages worked. He relied on the housing industry to get ahead in the business world and was eager to have his bank provide as many options as possible for consumers while capturing a formidable market share in an industry where competition was fierce and profit margins were shrinking.

Many consumers and brokers simply didn't "get" all of WaMu's options. Others clearly understood but were motivated by attractive commission fees or the possibility of living in a home they could not truly afford. The bank kept accepting the loans from just about all who wanted to opt in. Now, many consumers simply can't opt out.

To get even more valuable advice from Tom, visit his Second Home Center.

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