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A Good Example of How Not to Run a Bank

Morgan Housel

The Federal Deposit Insurance Corp. is suing a handful of former Washington Mutual executives for gross negligence and breach of fiduciary duty. WaMu, now part of JPMorgan Chase (NYSE: JPM - News), failed in 2008 -- the largest bank failure in history.The lawsuits aren't a surprise. The FDIC's 63-page complaint, however, makes for fascinating reading, giving gory details how WaMu voluntarily drove itself off a cliff.Take, for example, an email between former CEO Kerry Killinger, former Chief Operating Officer Stephen Rotella, and home loans head David Schneider. Discussing a surge of borrowers facing payment shock after their adjustable-rate mortgages reset to levels they couldn't possibly afford, Schneider wrote in late 2007:None of these borrowers ever expected that they would have to pay at a rate greater than the start rate. In fact, for the most part they were qualified at the start rate. ... When we booked these loans, we anticipated an average life of 2 years and never really anticipated the rate adjustments.This is unimaginably foolish. And this isn't a case of hindsight being 20-20. WaMu was making loans to borrowers it knew couldn't afford them, counting on the hope that homeowners would sell or refinance before reality came home to roost. Countrywide, now part of Bank of America (NYSE: BAC - News), and Golden West, now part of Wells Fargo (NYSE: WFC - News), went hog wild with similar adjustable-rate products that homeowners never stood a chance of affording. The outcome for shareholders would have been entirely predictable had these emails been public knowledge.The inanity of this program didn't just creep up on WaMu during the 2007-2008 meltdown. In 2005, the bank's chief credit officer notified senior managers that:The organization is at significant risk in its Option ARM and Hybrid portfolio of payment shock created by abnormally low Start -- or teaser -- rates, and aggressively low underwriting rates. ... It is our contention that in the upwardly sloping rate environment and expected flattening of housing appreciation, we are putting borrowers into homes that they simply cannot afford.Around that same time, CEO Killinger wrote an email acknowledging the housing market was losing its head. "I have never seen such a high risk housing market as market after market thinks they are unique and for whatever reason are not likely to experience price declines. This typically signifies a bubble."What's weird about this comment is that by making loans it knew borrowers could not afford, WaMu was basically assuming that it, too, for whatever reason, was unique. WaMu was the bubble that WaMu was warning about. This is a common theme in the FDIC's complaint: WaMu's downfall may have been caused more by hubris than stupidity.Here's another example. In a 2004 internal email, Killinger noted (emphasis mine):We believe the pendulum has swung a little too far to the side of risk management over the last couple of years. It is important that we all focus on growth initiatives and risk taking. Above average creation of shareholder value requires significant risk taking.Since when? The only thing that requires significant risk-taking is significant risk.Creating above-average shareholder value involves exploiting a market niche and securing that niche with a moat. That's it. Anyone can take risk. Only good businesses generate above-average value.Moving on to exhibit No. 3: By June 2006, Killinger's bearish view was evident. "We expect the housing market to be weak for quite some time as we unwind the speculative bubble. ... A collapse in the housing market would significantly increase our credit costs," he said in a memo.The strategy? "Our plans for the next three years include reducing interest rate risk and replacing that risk with greater credit risk." Why? "Wall Street appears to assign higher P/Es to companies embracing credit risk and penalizes companies with higher interest rate and operating risks," he wrote.This kind of attitude is sadly rife among public companies, but consistently leads to the same outcome. Running your company with the goal of pleasing Wall Street is the most reliable way to ensure your shareholders misery. A decision to take on more risk should have only come if it made good business sense. And it clearly didn't -- Killinger admitted credit costs were already increasing.There are dozens more examples of WaMu's executives' misdeeds in the FDIC's complaint. And the report makes it clear that not only did WaMu's leaders utterly fail at risk management, but they did so while being fully aware of it. They knew homeowners couldn't afford their loans. They knew housing was a bubble. They knew it was a house of cards. Yet they kept pushing along. It's like former Citigroup (NYSE: C - News) CEO Chuck Prince's infamous quote: "As long as the music is playing, you've got to get up and dance."But you have to ask why. It's difficult to know that, but Motley Fool CEO Tom Gardner makes as good an argument as anyone: "Killinger took home $88 million in the seven years preceding the collapse of the bank. ... [He] apparently designed a gimme-gimme culture fueled by reckless urgency and deceit. He hasn't returned a dime of his compensation."The fact is a lot of these managers walked away from their fallen companies very, very rich men. Even after their stock-based compensation became worthless, years of accumulated cash bonuses tied to bubble-fueled profits left them wealthier than most of us can ever imagine. From their personal perspective, mindful recklessness may have been a rational move.Fool contributor Morgan Housel owns B of A preferred. The Fool owns shares of Bank of America, JPMorgan Chase, and Wells Fargo. Through a separate Rising Star portfolio, the Fool also has a short position in Bank of America. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.