Washington Mutual’s Evolution from Savings and Loan to Integrated Mortgage Bank

The path of Washington Mutual (hereafter WaMu) to becoming a vertically in­tegrated bank was perhaps the most straightforward of our four case studies. The bank started out in the savings and loan business by taking deposits from customers and loaning many of those same customers the money to buy a house.

WaMu aimed to become a full-service retail bank that would offer all kinds of financial services to its customers. Its vision was to become like Walmart or Costco as a supplier of insurance, retirement plans, consumer loans, credit cards, and, of course, home mortgages. But like Countrywide and Bear Stearns, the businesses it eventually found to be most lucrative were centered on mortgage financing and securitization. As it built itself out, WaMu entered the nonconven- tional mortgage market, bought and sold MBSs based on the mortgages it orig­inated in that market, and held many on its own account. Eventually, it entered the investment banking business and began to issue and underwrite its own se­curities. It too relied on borrowed money to do much of this. While it retained its extensive retail business focused on savings accounts, credit cards, and personal loans, by 2002, it looked remarkably like both Countrywide and Bear Stearns.

Like those banks, it discovered that the market for mortgages and mortgage se­curitization was so large that it easily became the biggest and most profitable set of opportunities available. It had expanded across the country and was involved in the origination and securitization business everywhere.

WaMu had a long history in the city of Seattle. On June 6, 1889, the city expe­rienced a large fire that destroyed much of the downtown area. The Washington National Building Loan and Investment Association came into existence on Sep­tember 25, 1889, and began to take deposits to offer homeowners the opportunity to rebuild their homes. The company was organized as a mutual company, which means that its depositors were its owners, much like in a credit union. It made more than two thousand loans in the first twenty years of its existence. On June 25, 1908, the company changed its name to Washington Savings and Loan As­sociation. The company stayed a mutual savings bank. It retained this structure until 1983. Before the Depression, it was the leading savings institution in Wash­ington State. Its main activities were providing small savers with bank accounts and providing homeowners with mortgages. The depositors were the owners, and the bank worked to act in their interests.

By all accounts, it was a pretty conventional savings and loan bank during the postwar era. It was subject to Regulation Q, which set interest rates on deposits and loans. It was also restricted in the types of products it could sell and its abil­ity to expand geographically. Its success was tied to a strong local economy. If the demand for mortgages was high and if interest rates remained relatively low, the bank prospered. It grew in the postwar era with the city of Seattle. But the same forces that began to destroy savings and loan banks all over the country in the 1970s began to impact WaMu. The high interest rates of the 1970s meant that the bank was increasingly unable to attract deposits as long as its ability to pay interest on deposits was fixed at a low rate.

In 1981, Lou Pepper, a man who had been a career lawyer most of his adult life, was called on to lead the bank. While the bank had all of the problems of other savings and loans, it did have a few advantages. First, it had a good reputation in the Pacific Northwest as a bank that treated its customers fairly and gave good service. Second, it had more than $1 billion in assets, which made it one of the largest savings and loan banks in the country. Pepper worked diligently to cut costs and managed to keep the bank stable in the early 1980s. One of his most important moves was to reorganize the bank as a savings and loan bank that was a publicly held corporation (American Banker, 1983). This change allowed the bank to raise money in the public markets in order to keep it afloat. It also gave the bank a new set of opportunities that were just opening up for the savings and loan industry.

As a result of its crisis, the industry had persuaded Congress to pass deregula- tory legislation that encouraged savings and loan banks to act more aggressively and take on more risk in order to insure their futures. Regulation Q had been abolished, and depository insurance had risen to $100,000 per account. Savings and loan banks were free to invest in any kind of financial investment including junk bonds, derivatives, and commercial real estate. Most of the banks that en­tered these riskier businesses failed. WaMu was an exception to this rule (Amer­ican Banker, 1983). Instead, the bank pursued a more prudent course to cut its costs, realign its assets to reflect the high-interest-rate environment, and begin to offer its customers more financial products such as mutual funds and consumer loans along with its traditional home loan business.

Pepper turned out to be an excellent manager.

By 1987, WaMu was in the business of not only taking deposits from custom­ers and selling mortgages but also selling other financial services to retail cus­tomers. They offered stocks and mutual funds; life, health, and property/casualty insurance; travel services; pension and actuarial service; and traditional banking services such as savings and checking accounts. Nonbanking business accounted for 14 percent of the bank's profits (National Mortgage News, 1987a). The compa­ny's profits grew dramatically, and its assets reached $5.6 billion.

Because WaMu was focused on the individual customer, it realized that in order to succeed, it needed to provide services in such a way that people would trust the bank. As financial products grew more complex, establishing and keep­ing this trust was part of the WaMu brand. For example, WaMu joined many banks in the 1970s and 1980s by introducing adjustable-rate mortgages.

Pepper worked hard to create a corporate culture that reflected his view of how customers needed to be treated. He created a committee to come up with corporate goals and values. The committee agreed that the firm should serve cus­tomers, workers, community, and shareholders equally. It also proposed that the firm would value ethics, respect, teamwork, innovation, and excellence. While this seems like so much corporate hype, Pepper got buy-in from many employ­ees who saw that the firm was a good place to work and one where nice guys did not finish last. In 1986, Pepper began to consider his retirement. He considered selling the bank to another bank. But he eventually decided to stay on as CEO and president. Killinger and Longbrake ran the bank in tandem for over a year. But in 1988, Pepper decided to retire, and Killinger was named president and, a year later, CEO and chairman of the board.

By the mid-1980s, the financial crisis of the savings and loan industry was in full swing. Savings and loan banks were failing all over the country. With dereg­ulation, many of them had made risky investments, and many of those invest­ments had failed. WaMu was one of the few of the large savings and loan banks to be in good financial condition. During this period, WaMu was profitable but not hugely so. Killinger announced a set of goals for the firm that implied making profitability the most important goal. He promised a 1 percent return on assets and a 15 percent return on equity in the nonfinancial services part of the business within two years. He also promised to cut back on unprofitable diversification and to focus on the consumer markets (National Mortgage News, 1989b).

To do this, Killinger did two things. First, he decided to cut back on some of the businesses that they had entered, such as insurance. Instead, he wanted to focus on three areas: residential lending, a full range of deposit offerings for re­tail customers, and sales of mutual funds, and tax-deferred annuities. Second, he intended to roll this out on a national scale (National Mortgage News, 1989a). In the next fifteen years, he did both of these things. Killinger oversaw the growth of WaMu to being one of the largest savings and loan banks in the country. He did this mostly by buying banks, many of which were failing.

In his first two years, Killinger bought eight small banks, adding close to $1 billion in assets. He doubled the size of the company and expanded its opera­tions from Washington State to Oregon (National Mortgage News, 1991a). This rapid growth was reflected in the huge increase in the stock price. The National Mortgage News reported that the stock price of the bank had increased by 178 percent in 1991 (National Mortgage News, 1992). That same article reported that Killinger had attained his 1 percent return on assets and had a 13.7 percent return on nonfinancial equity close to his goals. The article concluded that this occurred because “the bank has de-emphasized commercial real estate lending, decreased the wholesale investment portfolio, and sold off businesses which did not meet corporate objectives of high returns, short lead time, and minimal corporate re­sources.”

During the 1990s, WaMu engaged in several forms of product diversification. On the retail side, they expanded into offering checking accounts for customers and developed a large consumer credit business. In 1996, they bought two com­mercial banks in order to make loans to businesses. The bank was also expand­ing in servicing existing home and consumer loans. By 1996, they were servic­ing almost three hundred thousand loans with a value of $19.2 billion (National Mortgage News, 1997a). But their core business remained home loan origination. In 1996, they were the leading mortgage originator in Washington and Oregon (National Mortgage News, 1997b).

Killinger continued to absorb larger and larger banks. The big moment for the company came in 1997 when it entered into the bidding against Ahmanson (the largest savings and loan in the country, which operated under the name of Home Savings in California) for Great Western, then the second-largest savings and loan bank in the country. After a long campaign, they were able to buy the company. This purchase produced a foothold in California. It also made WaMu the biggest savings and loan bank in the country.

Even as WaMu was absorbing Great Western into its system, the CEO of Ah- manson, Charles Rhinehart, decided to offer WaMu the opportunity to buy his bank. Rhinehart believed that size was going to be the key to success in the bank­ing business. Since WaMu had taken over the obvious target for Ahmanson, it made sense to join forces with WaMu. Rhinehart reasoned that getting bigger was the key to a successful bank. The merger with Ahmanson not only solidified WaMus position as the largest savings and loan bank in the country, it made it the seventh-largest financial institution in the United States. It had more than two thousand branches and thirty thousand employees. When Pepper stepped down in 1988, the company had $7 billion in assets. After the merger with Ah- manson in 1998, WaMu had $150 billion.

The bank continued its pattern of buying banks across the country. It bought assets in Boston, Salt Lake City, Miami, and Texas and continued to purchase banks in California. It also continued to diversify its product lines. The bank began to purchase subprime lenders. It bought Long Beach Financial, one of the largest subprime lenders, in 1999 (National Mortgage News, 1999). This intro­duced it to the securitization business. In 2001, WaMu bought the assets of Fleet Bank. This acquisition allowed it to be number one in mortgage originations in the country and number two in servicing (American Banker, 2001). Later in the year, it bought Dime Bank, an NYC-based bank that gave WaMu access to that market for home loans and consumer checking accounts. The lowering of interest rates propelled the wave of refinancing of mortgages. WaMu was well positioned to take advantage and produced high growth and large profits. WaMu bought an investment bank in 2002 and began to underwrite its own securities. Like the other banks, WaMu used credit to buy some of these securities for its own account. By 2002, the bank had a more or less integrated pipeline that orig­inated both prime and subprime mortgages, packaged them into securities, sold those securities to investors, and invested in some of those securities on its own account.

Killinger wanted to continue the growth of the bank. During the refinancing boom of 2001-2003, the bank worked hard to grow its market share and fully participate. It also continued to expand its nonconventional mortgage business. WaMu continuously ran an ad campaign focused on the theme of “The Power of Yes.” Their basic message was that their goal was to work hard to approve anyone who wanted some kind of loan. The product that proved particularly attractive in this regard was called the option adjustable-rate mortgage, otherwise known as the option ARM. This product allowed borrowers to choose their payments every month. They could pay the full amount due, they could pay just the interest in a given month and not the principal, or they could choose to pay some frac­tion of the interest due. This last option meant that the interest not paid would be added to the mortgage total, resulting in a person owing more money than they did in the past month. This was called negative amortization. After five years, the loan would readjust, and the borrower would have to pay a fixed payment. This product sold well, but it became a ticking time bomb that eventually helped bring the company down (a story to be told later).

Between 1989 and 1999, WaMu became the largest producer of mortgages in the country. It did so mainly through an aggressive program of acquisitions of other banks. In the failing savings and loan industry and in the context of bank deregulation, WaMu gobbled up competitors across the country. It was able to do so because of its diversified product base and, ironically, its prudent lending practices. Its CEO, Kerry Killinger, and his executive team were adept at buy­ing and integrating banks of all sizes. They successfully cut costs at banks they bought and added their assets to the company. They were able to meet their profit goals, which were ambitious. This, in turn, raised the stock price, which allowed further acquisitions.

Underneath this spectacular growth was an increasing reliance on mortgage lending as the core business. Although WaMu had a substantial consumer busi­ness centered on savings, checking, personal loans, and financial products, the mortgage business was so large that it generally provided the largest growth prospects and the largest profits. WaMu was aggressive in entering the non- conventional loan markets, particularly subprime but also home equity loans. They used adjustable-rate mortgages strategically and provided option ARMs to buyers who were less able to afford house payments. They also were active producers of securities based on these mortgages and held large numbers on their books. Finally, WaMu actively worked to be the largest loan servicer in the country as well.

As a result, by 2002, their business model for success had produced rapid growth for the bank. That growth reflected the rapidly reorganized mortgage business that emphasized mortgage securitization and nonconventional mort­gages. The rapid growth of the company made it one of the industry leaders along with Countrywide Financial.