This is my MBA project paper of the External Audit course. The project paper was tapped to the hottest topics of the U.S. economic crisis in 2008, three months after the collapse of the biggest U.S. bank institution.
The author incorporated the audit principles in analyzing the root causes of the U.S. economic crisis and how this disaster can be avoided.
Washington Mutual Bank's Collapse Under An Audit Perspective
1. Keller Graduate School of Management
Devry University
*****
WASHINGTON MUTUAL'S COLLAPSE
under an audit perspective
AC 555 - EXTERNAL AUDTITING
Instructor: Senior Professor Ted Tully
Student: Khanh Chau
February 2009
San Jose Center
*****
2. Index
I. Prefix
II. Introduction
III. Washington Mutual Inc.
1. Washington Mutual Bank profile
2. Key personnel
IV. Washington Mutual Bank's problems
1. The Power of Yes
2. Wal-Mart banking
3. Referral fees for loans
4. Inflating property value
5. ARMs – Adjustable rate mortgage
6. No income verification
V. What make Washington Mutual Bank collapse?
1. Mortgage crisis
2. Changing business strategy
3. Negative financial outlook – Increasing loss reserves
4. Government regulatory – Red flag
5. Public’s high pressure – The boiler
6. Massive outflows – Depletion
7. Receivership
VI. The auditors: Deloitte
1. Where were the auditors
2. Was Deloitte aware of financial problems that WaMu faced?
3. What should Deloitte have done?
VII. Consequences
VIII. Conclusions
IX. Appendixes
1. Washington Mutual Bank 's financial statements 2005-2007 (abstract)
2. Disclosures of contingent credit risk liabilities
3. Deloitte's auditor reports
X. References
Khanh Chau - AC555 – Washington Mutual 2
3. I. PREFIX
“We hope to do to this industry what Wal- Mart did to theirs, Startbucks did to theirs,
Costco did to theirs and Lowe’s-Home Depot did to their industry. And I think if we’ve done our
job, five years from now you’re not going to call us a bank.” — Kerry K. Killinger, Chief
Executive of Washington Mutual, 2003 [1].
Yes, Kerry K. Killinger’s dream came true. Five years from 2003, Washington Mutual,
Inc., the largest U.S’s saving and loan association, lost its standing in the U.S. banking system. It
was sold off to JPMorgan Chase on September 25th 2008, which was the biggest failure in the
U.S. banking history.
II. INTRODUCTION
Washington Mutual, Inc. (abbreviated to WaMu), founded on September 25, 1889,
headquarters in Seattle, Washington, United States. Washington Mutual Inc. was the former
owner of Washington Mutual Bank, the United States’ largest saving and loan association.
Since the early 1990s, Washington Mutual Bank expanded its retail banking and lending
operations organically and through a series of key acquisitions of retail banks and mortgage
companies. The majority of growth resulted from acquisitions between 1996 and 2002. On
October 1, 2005, the Bank entered the credit card lending business by acquiring Providian
Financial Corporation. These acquisitions enabled Washington Mutual Bank to expand across
the country, to build its customer base, and to become the largest savings and loan association in
the country. The Bank had four business segments: the Retail Banking Group, the Card Services
Group, the Commercial Group, and the Home Loans Group. Washington Mutual Bank is a
Khanh Chau - AC555 – Washington Mutual 3
4. leading originator and servicer of both single and multi-family mortgages and a major issuer of
credit cards [11].
By mid of September 2008, under the fear of credit crunch and financial crisis of AIG,
Fannie Mae, and Freddie Mac, American consumers rushed to withdraw their deposit from
Washington Mutual Bank that created a massive deposit outflow with a total of $16.7 billion in
eight consecutive days. The incident pushed the company into an extremely critical situation to
have enough time to react through increasing the capital, improving the liquidity, or finding
equity partner. Given the Bank’s limited sources of funds and significant negative deposit,
government regulatory agency took a quick action to place Washington Mutual Bank under the
supervision of Office of Thrift Supervision (OTS), and then placed into the receivership of the
Federal Deposit Insurance Corporation (FDIC). Washington Mutual Inc. with the book value
assets of $307 billions was sold to JP Morgan Chase for $1.9 billions and now it operates as a
division of JP Morgan Chase. The holding company Washington Mutual, Inc. (the former bank
owner) subsequently filed for Chapter 11 bankruptcy, ending the history of a 120 year-old
company.
III. WASHINGTON MUTUAL INC.
1. Company Profile [2]
Parent company: Washington Mutual Inc.
Primary executive and business segment headquarters are located in Seattle, Washington.
Khanh Chau - AC555 – Washington Mutual 4
5. Subsidiaries: two banking subsidiaries: WMB and Washington Mutual Bank; and non-
banking subsidiaries: Washington Mutual Investments, Inc; Washington Mutual
Insurance Services; Washington Mutual Card Services.
Business segments: the Retail Banking Group, the Card Services Group, the Commercial
Group and the Home Loans Group.
Total assets as of June 30, 2008: US$307.02 billion.
Branches: 2,239 retail branch offices operating in 15 states.
4,932 owned and branded ATMs.
Employees: 43,198 as of June 30, 2008.
2. Key personnel [9]
Kerry K Killinger, born in 1949 in Iowa, was former
Chairman and former Chief of Executive Officer of Washington
Mutual Bank. Killinger received Bachelor of Business
Administration from the University of Iowa in 1970 and MBA in
1971. He began his career in the financial services industry in 1972
as an investment analyst with Bankers Life Insurance Company of Nebraska, and moved on to
Murphey Favre in the 1976, where he first held the position of securities analyst and then was
promoted to vice president position.
When Washington Mutual Bank acquired Murphey Favre in 1983, Killing excelled
gradually in a higher career ladder. Killing was appointed as Executive Vice President after the
acquisition. He was then promoted to Senior Vice President in 1986, to Director in 1988, and to
President in the same year; Killing moved up to the CEO position in 1990, and the Chairman of
Khanh Chau - AC555 – Washington Mutual 5
6. company in 1991. Killing was named in the “List of 2001 Banker of The Year” for his
remarkable contribution to the company growth at that time. Between late 1996 and early 2002,
Killinger transformed Washington Mutual Bank into the nation’s sixth-largest bank through
series of acquisitions. When Washington Mutual Bank purchased Long Beach Financial in 1999,
a California lender specializing in subprime mortgages by extending loans to borrowers with
troubled credit, Killing hungered to push the company expansion with an amazing advertising
campaign “The Power of Yes” in 2003. Killinger walked the company to the top of its massive
lending in the most favorable economic conditions: upbeat housing price, housing value
appreciation, and booming demand of borrowings.
After several consecutive years of rising housing price and massive lending practices at
Washington Mutual Bank as well as at many other financial lending institutions, the subprime
mortgage crisis appeared on its horizon in late of 2006. By then, Washington Mutual Bank
continuously faced up mountain losses in mortgage market and steeply declines of its stock
price. On September 8, 2008, at the peak of the company crisis, the Board of Directors forced
Killinger to retire. Killinger has earned over $100 million during his tenure with the company
based on his aggressiveness that sunk the company. He has not returned any money to the
company's shareholders or employees as of December 2008.
IV. WASHINGTON MUTUAL BANK’S PROBLEMS
1. The Power of Yes
Killinger hungered to grow the company at all costs. He turned a banking company into a
loan factory, a Wal-Mart banking that bolstered with its famous amazing advertising campaign
“The Power of Yes”. To implement this business strategy, Washington Mutual Bank grew
Khanh Chau - AC555 – Washington Mutual 6
7. branches in 38 states at an astonished speed of a growing fast-food chain. It grew 70% in 3 years,
reaching to 2,200 branches across the country. Revenue at Washington Mutual Bank's home-
lending unit swelled from $707 million in 2002 to almost $2 billion in 2003 when “The Power of
Yes” campaign started.
At that time, Washington Mutual employees well exercised “The Power of Yes” in their
daily practices. A file would get marked problematic and then somehow get approved. “We’d
say: ‘O.K.! The power of yes.’ ” [1]
2. Wal-Mart banking
After 2000 and especially after the transition in leadership in 2005, Washington Mutual
Bank focused to the residential lending and related products as a driver of asset accumulation
and interest income. In 2006 and 2007, nearly 70% of interest income and 60% of overall
average assets were generated by residential real-estate loans. Washington Mutual Bank was like
a sweatshop with massive production, massive lending, Wal-Mart banking, or loan factory.
Employees were always under pressure to process loan applications within a limit time frame. In
most of the cases, loan officers ran behind the target and did not have enough time to review or
to properly evaluate the loan applications. If the loan target felt short, employees were ordered to
drive to other Washington Mutual offices to call customers to push the home equity loans. When
Washington Mutual Bank’s financial scandal unveiled, public was shocked to know that a small
office with 108 employees processed several hundred new files a days. Typically, an employee
was required to process at least 10 files daily. “I’d typically spend a maximum of 35 minutes per
file,” one Washington Mutual employee said, “It was just disheartening. Just spit it out and get
it done. That’s what they wanted us to do. Garbage in, and garbage out”[1].
Khanh Chau - AC555 – Washington Mutual 7
8. With enormous expansion of branches across the country to realize the dream of Wal-
Mart banking, loan officers were either unqualified or uninterested to help borrowers understand
terms of their loans. Washington Mutual Bank's lending practices was focused to meet the
quantity of loan applications rather than the quality of loan. Confidential Witness 5 believed that
“the majority” of Option ARM borrowers did not understand that their rate and payments would
go up after the teaser period (Complaint p. 38)[14].
3. Aggressive selling
Branches and sales agents were pressed to pump out loans to meet the loan budget. To
reach out to potential borrowers in every location of the country, Washington Mutual Bank
turned real- estate agents into a pipeline of loan applications by bringing more borrowers and
then collecting $10,000 referral fees. Money can make the devil dance. Real-estate agents made
everything possible to fast collect the referral fee. Very often real-estate agents pushed
Washington Mutual Bank's loan officers to sell riskiest loans to borrowers, who had little English
and relied heavily on the real-estate agent advices. Many subprime loans were not sought out by
borrowers but actively sold to them by brokers and telemarketers. “If you were alive, they would
give you a loan. Actually, I think if you were dead, they would still give you a loan.”[1]
4. Inflating property value
Business ethics seemed not to exist at Washington Mutual Bank. To pump up stock price,
Washington Mutual Bank pressured appraisers to provide inflated property values that made the
loans appear less risky, enabling Wall Street to bundle them more easily for sale to investors.
Earning manipulation was another accounting fraud at Washington Mutual Bank. In November
2007, the company faced a class action lawsuit alleging for over-inflating home appraisals while
also inflating prices. The lawsuit, which was filed on behalf of investors, states, "WaMu
Khanh Chau - AC555 – Washington Mutual 8
9. [Washington Mutual] told investors in mid-October 2007 that the company had suffered a 52-
percent drop in net income during the third quarter of 2007 and would have to set aside up to
$1.3 billion in the fourth quarter of 2007 to cover its losses. These write downs were caused, at
least in part, by the impairment of loan assets that were based on the inflated appraisals
fraudulently orchestrated by WaMu and eAppraiseIT"[13].
5. ARMs – Adjustable rate mortgage
Washington Mutual Bank aggressively introduced its adjustable rate mortgages ARMs to
the financial market to entice borrowers with a selection of low initial rates. It allowed borrowers
to decide how much they want to pay each month. Borrowers, who selected the minimum
payments, were underpaying the interest due that eventually added up to their principal, and
caused the loan exposing to a higher risk.
From Washington Mutual's perspective, the variable-rate loans, options of ARMs, were
especially attractive because Washington Mutual Bank could carry higher fees than other loans,
and allowed the company to book profits on interest payments that borrowers deferred.
Washington Mutual, in its lending practices, sold many of its loans to investors without worry of
defaults. A majority of the loans were refinance transactions allowing homeowners to take cash
out of their appreciating property or pay off credit card and other debt. Lenders that made the
risky loans often sold them to Wall Street investors [22]. Washington Mutual assumed that by the
time loans went bad, they were often in other hands of third party and Washington Mutual Bank
could be sound and safe. This assumption was conflict with the Management’s Discussion and
Analysis of Washington Mutual Bank's Annual Report of 2005. In its financial report,
Washington Mutual management claimed that, as the nature of lending business, the Contingent
Credit Risk Liabilities remained with Washington Mutual Bank, even when the loans were sold.
Khanh Chau - AC555 – Washington Mutual 9
10. This was because the company pledged making payments to remedy the default or repurchasing
if the loans became problem [21].
The adjustable-rate mortgages expanded from about 25% of new home loans in 2003 to
70% in 2006 represented more than 50% of Washington Mutual’s portfolio. In 2005 and 2006,
Washington Mutual Bank pushed the option ARMs most aggressively; during that period, Mr.
Killinger received pay of $19 million and $24 million respectively.
6. No income verification
At Washington Mutual Bank, getting the job done meant lending money to nearly anyone
who asked for it [1]. Borrowers were required to provide their addresses, social security
numbers, income, assets, and with good credit scores, their loan applications can be processed.
Loan officers intentionally or unintentionally ignored the illogical aspects of borrowers’
applications. They rarely asked any questions or raised any concerns, just passed through and
approved. In many cases, if bank officers cannot verify the borrowers’ income with blown-up
income and asset, and if any concerned applications brought to higher management levels, those
questionable applications were simply approved or solved by some internal creative tactics. A
borrower was advised to take himself a photograph, well dressed, in front of his home, then
attached the photo into a Washington Mutual file, loan application was passed through to
approve. A gardener claimed his monthly income of $12,000 in his loan application, “ Yes”.
Approved. Another occasion of income verification of an applicant’s assets, the officer sent a
letter from a bank showing a balance of about $150,000 in the borrower’s account, but the
officer called the bank to confirm, it was told the balance was only $5,000 [1].
Khanh Chau - AC555 – Washington Mutual 10
11. V. WHAT MAKE WASHINGTON MUTUAL BANK COLLAPSE [6]
Washington Mutual Bank's management stated in its annual report: The Company is
exposed to four major categories of risk: credit, liquidity, market, and operational [21]. Those
risks existed in Washington Mutual Bank daily practices. Operational risk especially exposed to
a high level, especially when the company was too aggressive in its selling plan and massive
expansion within a short period. The nature of the loan business was the credit risk that was
accelerated to an extreme risky level at Washington Mutual's loan factory, underlying poor credit
standards, lingering underwriting system and ambitious sales target. Washington Mutual Bank
was hit with the negative impact of U.S. mortgage crisis. When the outbreak of loan defaults,
housing foreclosure spread out national wide for a long period enough, the economic and
financial systems became weakening, leading to the U.S financial crisis and causing immense
collapses of financial institution and the U.S. banking system. These incidents presented how the
market risks affect the businesses and as well as the nation as a whole. In that lousy financial
picture, clients were fearful of losing everything. They headed to withdraw their deposits; the
massive outflows quickly depleted Washington Mutual Bank's resources and capital, put the
company at a high liquidity risk and forced to bankruptcy. Washington Mutual Bank may not
anticipate a badly-ever economic scenario can be happened when all business risks occur
simultaneously and at the magnitude of a tsunami that eventually swept out the company in an
instant.
1. Mortgage crisis
U.S. housing prices were peak in early 2005, downward in 2006, and continued to the
lower end pricing. The deflation of housing price made mortgage debt higher than the value of
the property, causing many homeowners becomes negative equity. With inflated income stated
Khanh Chau - AC555 – Washington Mutual 11
12. on the loan applications, loan borrowers faced with the reality that they had never anticipated:
they were no longer afforded to pay interest and installment. Delinquencies and defaults rose
continuously leading to the country sub-prime mortgage crisis. In 2006, Washington Mutual
Bank slowed down their option ARM lending, but the company begun to hurt by its ill-
considered loans.
2. Changing business strategy
Late of 2006, Washington Mutual Bank was actively changing its business strategy to
respond to the declining housing and market conditions. The company tightened credit standards,
eliminated purchasing subprime mortgage loans, and discontinued underwriting option ARM.
Management reduced loans originated for sale and transferred held-for-sale loans to the held-for-
investment portfolio. Washington Mutual Bank was to focus shrinking its balance sheet and
developing a retail strategy through its branch operations. The company aimed to reduce
overhead cost by resizing its Home Loans business including the elimination of approximately
2,600 employee positions, closing approximately 190 home loan centers and sales offices, and 9
loan processing and call centers.
Late 2006 and 2007, Washington Mutual Bank began to increase its capital and its
reserves through asset shrinkage and the sale of lower-yielding assets. In April 2008,
Washington Mutual Bank received $7.0 billion of new capital from the issuance of common
stock. Since December 2007, Washington Mutual Bank infused $6.5 billion into their financial
statements and met the well-capitalized standards through the date of receivership.
3. Negative financial outlook - Increasing loss reserves
Since its slogan “The Power of Yes” began in 2003, Washington Mutual Bank did a lot
of mortgage lending in California and Florida, where both states have had massive foreclosures.
Khanh Chau - AC555 – Washington Mutual 12
13. In 2007, the company recorded a $67 million loss and shut down its sub-prime lending unit. By
the end of June 2008, the company recorded net loss of $6.1 billion for three quarters and
anticipated a potential loss of $19 billion on its single-family residential mortgage portfolio.
When the market conditions were deteriorating in the secondary mortgage, Washington Mutual
Bank increased loss reserves by about $500 million in September 2008 that was about 30%
higher than it had indicated in July of 2008.
4. Government regulatory – Red flag
A higher loss reserves hurt Washington Mutual Bank’s earnings and jeopardized the
company financial health. The government regulatory agency, with critical eyes, pointed out the
following underlined problems from Washington Mutual Bank's negative earning trends:
Total provisions for loan and lease losses expense up 480% year-over-year and 160%
sequentially, to $967 million.
Net charge-offs up 170% year-over-year and 55% sequentially, to $421 million.
Non-performing asset ratio up 96 basis points year-over-year and 36 basis points
sequentially, to 1.65% of total assets.
Total customer deposits were below $200 billion for the first time in more than a year and
a half, down 7.9% year-over-year and 3.5% sequentially.
5. Public’s pressure – The boiler
The situations became further deteriorated by mid of September 2008 after the
countrywide reported another worsening of foreclosures and delinquents. Public increased
pressure on Washington Mutual Bank's lingering financial health as the market conditions
continued to worsen. Creditors deeply concerned if the financial crisis sunk deeper, how could
Khanh Chau - AC555 – Washington Mutual 13
14. Washington Mutual Bank thrive to overcome the crisis and survive? Most probably, Washington
Mutual Bank did not know and cannot find any quick answers to address their problems:
How much further will loan loss reserves increase?
How much more of its assets will end up as nonperforming?
Will total deposits continue to decline?
Given the above, will the company be able to remain liquid? If so, how?
Is Washington Mutual Bank guilty of encouraging inflated appraisals?
Is CEO Kerry Killinger the right man to dig the company out of its problems?
In any healthy capital market, there's a risk/reward trade off.
6. Massive outflows – Depletion
Eventually the tsunami started its power; Washington Mutual Bank cannot stand and
survive in its turbulence. When Lehman filed for bankruptcy protection on September 15 th, 2008,
Washington Mutual Bank's customers began heading for the exits. Over the next 10 days,
customers withdrew a total of $16.7 billion in deposits that was about 9% of the thrift's deposits
as of June 30 [5]. Such massive outflows depleted the company so quick, caused a sudden cash
imbalance, and gave the company limited time to increase capital, improve liquidity, or find an
equity partner.
7. Receivership
Given the Bank’s limited resources of funding and significant deposit outflows,
government regulatory agency were highly concerned about Washington Mutual Bank's stability
and safety to continue its businesses and to be able to pay off
its obligations and to meet its operating liquidity needs. Office
Khanh Chau - AC555 – Washington Mutual 14
15. of Thrift Supervision (OTS) decided to place Washington Mutual Bank into receivership on
September 25, 2008 and sold to JPMorgan Chase. OTS acted quickly in few days for this
important decision to avoid another massive deposit outflows that might pushed another sunk to
the weakening U.S. banking systems. Appointed officials at the FDIC were concerned that if the
failure of Washington Mutual was followed by other bank failures as well, the agency would not
be able to handle the situation [12]. The change had no impact on the bank’s depositors or any
customers. On the following Friday morning, September 26, 2008, Washington Mutual branches
open as usual with normal business transaction, but under the name of a JPMorgan Chase
division.
VI. THE AUDITORS- DELOITTE
Deloitte Touché Tohmatsu (also branded as Deloitte.) founded in 1845, is one of the
largest professional services firms in the world, one of the Big Four Companies, along with
PricewaterhouseCoopers, Ernst & Young, and KPMG. Deloitte has revenue of US$27.4 billion
in 2008 and approximately 165,000 professionals at work in 140 countries. Its global
headquarters are located in New York City, New York ad European headquarters are located in
London. The company involves in the audit, tax, consulting, and financial advisory services.
1. Where were the auditors?
Deloitte has been Washington Mutual Bank’s auditors from 2005 to 2007, a period long
enough to understand the client’s business risks, to identify the areas of internal control
weaknesses or potential material misstatements. During the course of three years auditing at
Washington Mutual Bank, were Deloitte auditors aware of Washington Mutual Bank’s poor
accounting systems, high governance risks, potential litigation or liquidity? When mortgage
Khanh Chau - AC555 – Washington Mutual 15
16. crisis spread out in 2006 with increasing immense number of home defaults and delinquencies
national wide, the mortgage lending industry obviously underlined an extremely high business
risk areas. Did Deloitte's auditors assess maximum business risks and inherent risks in their audit
at Washington Mutual Bank? During the audit process from 2007-2008, did Deloitte's auditors
notice Washington Mutual Bank extremely weak balance sheet and income statements through
increasing higher loss reserves and consecutive negative earnings? Did Deloitte's auditors ever
question about Washington Mutual Bank’s ongoing-concern and liquidity problems under the
current weakening financial market of 2007 and 2008? Four months after Deloitte's auditors
issued a clean report accompanied with Washington Mutual Bank’s 2007 10KA that was filed in
May 2008, Washington Mutual Bank’s quick downfall and instant collapse stunned the publics.
Public filed a lawsuit action against Deloitte, claimed that Deloitte auditors did not exercise
sufficient care and diligence in their reviews of Washington Mutual Bank’s financial statements
of annual report [18].
2. Was Deloitte aware of the financial problems that Washington Mutual faced?
To get a clearer picture of Washington Mutual Bank’s financial health during the
mortgage crisis, the author collects financial data from Hoover’s source [20] and composes a
table of financial ratio analysis for the period of 2005-2007, which were the peak and the fall of
Washington Mutual Bank before its collapses. The financial ratios analysis reveals a clear
evidence of Washington Mutual Bank’s ongoing concern and weak financial position long before
its collapse. The analysis indicates an exceptionally high red alert on Washington Mutual Bank's
financial position with awfully unbalanced liquidity and solvency ratios that required
Washington Mutual Bank immediately increased its reserves and capital to strengthen their
balance sheet, to meet urgent short-term cash needs and long-term debt obligations.
Khanh Chau - AC555 – Washington Mutual 16
17. Table 1- Financial ratios analysis - Washington Mutual's performance and financial health
Financial ratios Unit Dec 07 Dec 06 Dec 05 Note
Liquidity
Negative working capital and
Current ratio % 0.084 0.082 0.091 extremely low current ratio,
current cash debt coverage
ratios are ALL IN RED, that
Working capital $ mio (230,848) (252,352) (258,694)
indicated an unfavorable
Current cash debt liquidity to meet obligations or
coverage ratio unexpected urgent cash needs.
Times 0.031 0.026 0.006
Solvency
Debt to total assets
ratios DA % 0.925 0.922 0.921 Very low ratios of cash debt
coverage ratios and free cash
Cash debt coverage
flow available to total
ratios Times 0.025 0.023 0.006 liabilities ratios indicated the
company unfavorable solvency
Free cash flow $ mio 5,431 4,842 (551) and incapability to meet the
Free cash obligations in a long run.
flow/current liabilities % 0.022 0.018 (0.002)
Management efficiency
All weak ratios indicated the
Net Profit Margin % -- 13% 16% company poor sales
performance from each dollar
Return on asset ROA % (0.000) 0.010 0.010 invested in assets or equity,
and the management’s
ineffective in using its
Return on equity ROE (0.003) 0.131 0.126 resources to generate sales.
With a little research of
industry and financial risk
indicator, the auditors can easily
identify the client business risks.
Khanh Chau - AC555 – Washington Mutual 17
18. The Accounting & Governance Risk (AGR®) rating is a good indicator. The ARG, developed by
industry experts, is an assessment of the quality and transparency of corporate behavior. The
AGR scores are based on statistical analysis of accounting and governance risk factors. Lower
scores indicate heightened corporate integrity risk, an increased likelihood of future litigation,
material financial restatements, or impaired equity performance. Monthly AGRs of Washington
Mutual Inc. during the period March 2006 to June 2008 have been all in red indicating ”very
aggressive” approaches in Washington Mutual Inc. 's accounting and governance risk, including
its subsidiary Washington Mutual Bank.
Washington Mutual, Inc. is currently rated as having Very Aggressive Accounting &
Governance Risk (AGR), receiving an AGR Score of 21 out of a possible 100. This places them
in the 4th percentile among all companies, indicating higher Accounting & Governance Risk
(AGR) than 96% of companies. The forensic risk summary table below highlights materials risks,
if any, and lists the most critical business issue for each risk. AGR Impact shows the deductions
from a perfect 100 AGR score due to flagged matrics. [16]
RISK AGR® TOP ISSUE
IMPACT
Corporate Governance Events -49.35 Avg Ratio of Incentive to Annual Comp of
CEO & CFO
High Risk Events -14.077 Restructuring
Revenue Recognition -15.572 Non-Interest Income/Non-Interest Expenses
Expense Recognition -0 N/A
Asset-Liability Valuation -0 N/A
With little effort to do the research for the Washington Mutual's ARG score, couple with
applying analytical procedure and financial ratio analysis, Deloitte auditors could obviously find
out the aggressive level of Washington Mutual’s accounting and governance risks. If Deloitte
auditors exercised enough professional care and acted differently in their audit planning, audit
Khanh Chau - AC555 – Washington Mutual 18
19. procedures, and audit opinion, Deloitte auditors would be able to send a red flag earlier to the
public to alert about Washington Mutual Bank’s business risks that may help financial users
made different investment decisions.
3. What should Deloitte have done?
The investigation of Washington Mutual Bank lawsuit is on progress. The material
weaknesses of internal control and accounting frauds at Washington Mutual Bank will be
scrutinized and soon unveiled to the public. At this point, in the scope of a project paper of the
External Auditing class, the author’s attempt to outline the visible failures of Deloitte's auditors
in their audit practices at Washington Mutual Bank and what they should have done differently
to avoid the U.S. financial crisis. The author takes a closer look and analyzes the following
sources of documents: (1) evidences or witnesses involved in the lawsuit unveiled on media; (2)
Washington Mutual Bank's 10K of 2005. The author's rational to select the annual report of 2005
as the peak year of Washington Mutual Bank in its home lending businesses when the housing
market flourished and Washington Mutual Bank was still in good standing as a going-concern.
The author would like to address the following possible weakness areas of Deloitte's audit
procedures, audit practices to highlight Deloitte‘s potential miss-application in assessing client
business risks.
An appropriate assessment of risk is the foundation of a high quality audit. Today’s
proposals are intended to strengthen that foundation, which should result in improvements
throughout the audit”[8].
Professional skepticism should be maintained through out the audit. The fast growing
sales in home loan business and booming assets of Washington Mutual’s balance sheets sent a
Khanh Chau - AC555 – Washington Mutual 19
20. signal of potential misstatements or internal weaknesses. With professional skepticism, Deloitte's
auditors should have raised sustainable concerns about (1) Washington Mutual Bank’s
aggressiveness; (2) what and how the company maintained and achieved a tremendous fast-
paced organic growth 5 years in rows; (3) was there any hidden motivation of executive
compensation that exposed the company to an extreme challenging business risk? Employees
complaints repeatedly stated that policy dictated from the highest levels encourage aggressive
selling, wholesale noncompliance with company underwriting standards, fictitious appraisals,
and “tremendous pressure from the sales guys to approve loans” and that, with the involvement
of WaMu management, even questionable loans “usually got taken care of one way or another.”
(Complaint p. 36) [14]. If Deloitte auditors were to study Washington Mutual Bank's policy and
business plan carefully and to exercise sufficient due diligent, they should have noticed those
alerts.
Clues of Employment dissatisfaction and turnover of key senior personnel can be
identified through obtaining an understanding of the client’s business, touring around the factory,
talking with people, and observing employment disagreement if it did exist. When Washington
Mutual Bank's scandal brought to light, a lot of employee complaints unveiled to the public and
the quality of auditors’ observation was really in question! Did the auditors detect the clues of
internal employment dissatisfaction and high staff turnover at a high level of senior executive at
Washington Mutual Bank? Confidential Witness 17, a former Senior Vice President of
Enterprise Risk Management, “explained that various Risk Reports were delivered to
Washington Mutual Bank’s senior management during 2006 ‘specifically quantified the fact that
the Company was exceeding certain risk parameters as dictated by [WaMu’s] risk
guidelines’”… CW 17 and other senior, experienced risk management leaders chose to leave the
Khanh Chau - AC555 – Washington Mutual 20
21. company during the class period rather than be parties to the policies being directed by top-level
executives [14].
Observation, documentation and walk-through process are important steps of audit
process. A deep study of corporate policy, loan application combined with observation of client’s
daily practices and a walk-through process may help to identify the current negligence, frauds,
and internal weaknesses at Washington Mutual in its loan lending and risk standard practices.
Missing important information on borrowers' loan applications, unmatched income against
borrowers' profession can reveal a poor internal control in loan granting and credit granting.
Underwriting and risk management standards were other problematic areas indicating
materially weakened or ignored with the increasing commitment during the period beginning in
2005. [14]
Analytical procedure should be undertaken extensively in both audit planning and
completing processes. In the analytical procedure process, the auditors should have researched
the industry related information, obtained client’s AGR risk scores, analyzed and compared
client’s financial ratios with industry averages. There were many clear and obvious evidences of
Washington Mutual Bank's high business risks: U.S. weakening mortgage lending industry in
2007 when subprime mortgage crisis spread out national wide; Washington Mutual Bank's poor
rating of accounting and governance risk; Washington Mutual Bank's red alert of financial ratios.
These evidences would have driven Deloitte's auditors to assess a maximum of client’s business
risk, inherent risk, control risk, and to perform audit planning with greater professional care and
ethical practices.
The auditors are required to issue an opinion about the fairness of presentation of the
client's financial report under the audit. One scope of audit was to scrutinize and analyze the
Khanh Chau - AC555 – Washington Mutual 21
22. disclosures and its adequacy of client's financial report. In the Management Discussion and
Analysis session of Washington Mutual Bank's financial report of 2005 and in the disclosure of
Contingent Credit Risk Liabilities, Washington Mutual Bank management stated the retaining
credit risk exposure on those loans sold to third party remained Washington Mutual Bank's
responsibility as contingent risk liabilities. Washington Mutual' assumed that the company would
be sound and safe in its subprime mortgage lending to unqualified borrowers and the risks of
loan default were shifted to third parties. That assumption was lingering and inconsistent with
what Washington Mutual Bank management disclosed in its annual report that stated
Washington Mutual Bank would engage to buy back default loans when negative scenario was to
be happened. Despite the company claimed that was a normal business practice of a lending
company, but it was a strong indication of an extreme risky business.
The above analysis shows abundant evidences of Deloitte auditors’ negligence and
ineffective in its audit practices. If Deloitte auditors acted differently with due care process,
complied with audit standards at the very earlier years of their audit life at this client, they should
have assessed maximum of inherent risk, acceptable audit risk, control risk in the audit;
expanded tests of business transactions, tests of details balances; increased sample size, changed
audit procedures with different approaches to uncover the accounting frauds and internal control
weaknesses at Washington Mutual Bank. Most important, it would be helpful to Washington
Mutual to change or to modify its business practices and to prevent its disastrous collapse and
litigation.
VII. CONSEQUENCES
When Washington Mutual Bank collapsed, the public was shocked knowing the secret of
Washington Mutual's business practices during the last 5 years. Washington Mutual Bank's stock
Khanh Chau - AC555 – Washington Mutual 22
23. price plummeted dramatically from some thirty dollars down to few cents before Washington
Mutual Bank was sold to Chase. Direct investors in Washington Mutual Bank's securities and
related derivatives lost substantial money, and seek to claim relief from these losses. Deloitte has
been named as a defendant in a securities lawsuit against Washington Mutual Bank. The class-
action complaint, filed Aug 5 by New York-based Bernstein Litowitz Berger & Grossmann LLP,
alleges Deloitte didn’t exercise sufficient care and diligence in its reviews of Washington Mutual
Bank’s financial statements in annual reports.
Washington Mutual Bank's collapse was the biggest bank failure in the American history.
It's a tragedy for its 43,000 employees, investors, and perhaps even depositors who handed the
bank over $100,000. Home borrowers, who got the loans from Washington Mutual Bank, went
to foreclosure and lost their homes, because they cannot afford to pay piles of interests and
adding-up principals. It was heartbreak because they would never know and never understand
how their loan interest was to calculate. Other home borrowers, who still can keep their homes,
become negative in home equity when their property values are below the loan valuations.
Inflated home appraisal hurt the homeowners who now have to pay more for the homes than its
worth and they would be impossible to get refinance from their inflated properties.
The extreme risky and unethical practices of Washington Mutual Bank in home loan
lending business was one of the roots of the U.S. mortgage crisis that has triggered mortgage
delinquencies and foreclosures spreading around the country, affected almost everyone. The fear
of foreclosure, jobless, uncertainty, mentality distress among American people and the weakened
U.S. consumer spending to the ever historical low; businesses lowered production capacity or
went bankruptcy; unexpected unemployment rate is raising everyday.
Khanh Chau - AC555 – Washington Mutual 23
24. On a larger scale, the mortgage crisis negatively has impacted to U.S. financial market,
U.S. banking systems; push the U.S. into a deeper economic recession. U.S. government has
signed hundreds billion dollars of bailout to rescue the economic, sunk the country in a deeper
foreign debts that will affect the future generation of U.S. taxpayers. Every of us pay for the
home mortgage crisis. The sub prime mortgage crisis is threatening to put the U.S. economy into
a recession. This primer tracks how the subprime crisis unfolded, affecting first the real estate
market and now the economy overall. It gives you definitions of important terms. It also explains
how interest rates and real estate play an integral role in the U.S. economy. Finally, it gives
resources for those who are suffering from the sub prime mortgage crisis directly.
VIII.CONCLUSION
The public has yet another high-profile auditing failure, loss of confidence in the market,
and no directly effective remedy. It could be useful to examine the lessons from Washington
Mutual Bank and Deloitte’s failure: the decisions that brought them to collapse, the warnings
ignored, the laws broken, and what this bank failure says about the audit industry [15].Law
enforcement and punishment on Washington Mutual and Deloitte will be soon publicized. How
about government authorities and oversight agencies in this collapse? What did SEC, PCAOB,
FED do their oversight responsibilities on those business activities that have affected the public
at large? Is there the loophole of the law? "The law does not discourage banks from lending to
home buyers who do not qualify for traditional loans. Indeed, Washington Mutual's regulator
encouraged the practices, as it opened the possibility of home ownership to a wider segment of
the population and permitted Washington Mutual to earn higher returns for investors in exchange
for taking on increased risk.’’[19]. Public need appropriate answers and resolutions to those
questions.
Khanh Chau - AC555 – Washington Mutual 24
25. IX. APPENDIXES
APPENDIX 1 – WASHINGTON MUTUAL INC – FINANCIAL STATEMENTS
Table 2- Washington Mutual, Inc. - Income statements 2005 – 2007
Source of Hoovers.com.proxy.devryu.edu [20]
($ mio) Dec 07 Dec 06 Dec 05
Revenue 26,523 26,454 21,667
Cost of Goods Sold 6,610 6,263 3,728
Gross Profit 19,913 20,191 17,939
Gross Profit Margin 75.10% 76.30% 82.80%
SG&A Expense 14,195 8,966 5,871
Depreciation & Amortization 504 827 2,656
Operating Income 5,214 10,398 9,412
Operating Margin 19.70% 39.30% 43.40%
Nonoperating Income -- -- --
Nonoperating Expenses 4,702 5,523 3,974
Income Before Taxes 309 4,770 5,438
Income Taxes 376 1,656 2,006
Net Income After Taxes -67 3,114 3,432
Continuing Operations -67 3,114 3,432
Discontinued Operations -- 444 --
Total Operations -67 3,558 3,432
Total Net Income -67 3558 3432
Net Profit Margin -- 13.40% 15.80%
Table 3 - Washington Mutual, Inc. - Statement of cash flow - 2005-2007
Source of Hoovers.com.proxy.devryu.edu [20]
Dec 07 Dec 06 Dec 05
Net Operating Cash Flow 7,697 7,269 1,765
Net Investing Cash Flow 12,228 168 -14,618
Net Financing Cash Flow -17,313 -6,703 14,612
Net Change in Cash 2,612 734 1,759
Depreciation & Amortization 504 827 2,656
Capital Expenditures -321 -441 -607
Cash Dividends Paid -1,945 -1,986 -1,709
Khanh Chau - AC555 – Washington Mutual 25
26. Table 4 - Washington Mutual, Inc. - Balance sheet statements - 2005-2007
Source of Hoovers.com.proxy.devryu.edu [20]
Total Assets Dec 07 Dec 06 Dec 05
Cash 14,205 15,125 19,350
Net Receivables 6,876 7,507 6,507
Inventories -- -- --
Other Current Assets -- -- --
Total Current Assets 21,081 22,632 25,857
Net Fixed Assets 3,758 3,522 3,538
Other Noncurrent Assets 303,074 320,134 314,178
Total Assets 327,913 346,288 343,573
Liabilities and Shareholder's Equity
Accounts Payable -- -- --
Short-Term Debt 70,003 61,028 91,384
Other Current Liabilities 181,926 213,956 193,167
Total Current Liabilities 251,929 274,984 284,551
Long-Term Debt 38,958 32,852 23,777
Other Noncurrent Liabilities 12,442 11,483 7,966
Total Liabilities 303,329 319,319 316,294
Shareholder's Equity
Preferred Stock Equity 3,392 492 --
Common Stock Equity 21,192 26,477 27,279
Total Equity 24,584 26,969 27,279
Shares Outstanding (mil.) 113 113 113
Table 5 - Historical Financials
Source of Hoovers.com.proxy.devryu.edu [20]
Net
Year Assets Income as Employees
Income
% of
($ mil.) ($ mil.)
Assets
Dec 2007 327,913.00 -67 0.00% 49,403
Dec 2006 346,288.00 3,558.00 1.00% 49,824
Dec 2005 343,573.00 3,432.00 1.00% 60,798
Khanh Chau - AC555 – Washington Mutual 26
27. Table 6- Computation of WaMu’s financial ratios for period 2005 - 2007
(Source Hoover’s data from table 2- table 3 – table 4 [20])
I. Financial strength
Liquidity Dec 08 Dec 07 Dec 06 Dec 05
Current ratio 0.08 0.08 0.09
Total Current Assets 21,081 22,632 25,857
Total Current Liabilities 251,929 274,984 284,551
Working capital -230,848 -252,352 -258,694
Current cash debt coverage ratio 0.03 0.03 0.01
Net Operating Cash Flow 7,697 7,269 1,765
Total Current Liabilities 251,929 274,984 284,551
Solvency Dec 08 Dec 07 Dec 06 Dec 05
Debt to total assets ratios DA 0.93 0.92 0.92
Total Liabilities 303,329 319,319 316,294
Total Assets 327,913 346,288 343,573
Cash debt coverage ratios 0.03 0.02 0.01
Net Operating Cash Flow 7,697 7,269 1,765
Total Liabilities 303,329 319,319 316,294
Free cash flow 5,431 4,842 -551
Net Operating Cash Flow 7,697 7,269 1,765
Capital Expenditures -321 -441 -607
Cash Dividends Paid -1,945 -1,986 -1,709
II. Profitability Dec 08 Dec 07 Dec 06 Dec 05
Asset turnover ratio 0.08 0.08 0.06
Net sales 26,523 6,454 21,667
Total Assets 327,913 346,288 343,573
Net Profit Margin -- 13% 16%
III. Management efficiency Washington Mutual, Inc. Industry S&P 500
Dec 08 Dec 07 Dec 06 Dec 05 Dec 08 Dec 08
ROA (1.98) (0.00) 0.01 0.01 0.06 5.83
Net income -67 3,558 3,432
Total Assets 327,913 346,288 343,573
Return on Assets - 5 Yr. Avg. 0.81 0.53 6.22
ROE (0.00) 0.13 0.13
Total Equity 24,584 26,969 27,279
Net income -67 3,558 3,432
Total Debt to Equity (MRQ) 12.34 11.84 11.59
Total Liabilities 303,329 319,319 316,294
Total Equity 24,584 26,969 27,279
Return on Equity - 5 Yr. Avg. 10.99 9.45 16.10
Khanh Chau - AC555 – Washington Mutual 27
28. APPENDIX 2 - DISCLOSURE OF CONTINGENT CREDIT RISK LIABILITIES
“In the ordinary course of business, the Company sells loans to third parties but retains
credit risk exposure on those loans. When loans are sold with retained credit risk provisions
attached to the sale, the Company commits to stand ready to perform, if the loan defaults, by
making payments to remedy the default or repurchasing the loan. The Company also sells loans
without retained credit risk that it may be required to repurchase for violation of a
representation or warranty made in connection with the sale of the loan that has a material
adverse effect on the value of the loan, or if the Company agreed to repurchase the loan in the
event of a first payment or early payment default. When a loan sold to an investor without
retained credit risk fails to perform according to its contractual terms, the investor will typically
review the loan file to search for errors that may have been made in the process of originating
the loan. If errors are discovered and it is determined that such errors constitute a violation of a
representation or warranty made to the investor in connection with the loan’s sale, then the
Company will be required to either repurchase the loan or indemnify the investor for losses
sustained if the violation had a material adverse effect on the value of the loan”
Khanh Chau - AC555 – Washington Mutual 28
29. APPENDIX 3- DELOITTE’s AUDITOR REPORTS
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
Washington Mutual, Inc.
We have audited management’s assessment, included in the accompanying Management’s
Report on Internal Control Over Financial Reporting, that Washington Mutual, Inc. and
subsidiaries (the “Company”) maintained effective internal control over financial reporting as of
December 31, 2005, based on criteria established in Internal Control – Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission. The
Company’s management is responsible for maintaining effective internal control over financial
reporting and for its assessment of the effectiveness of internal control over financial reporting.
Our responsibility is to express an opinion on management’s assessment and an opinion on the
effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting
Oversight Board (United States) (“PCAOB”). Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether effective internal control over financial
reporting was maintained in all material respects. Our audit included obtaining an understanding
of internal control over financial reporting, evaluating management’s assessment, testing and
evaluating the design and operating effectiveness of internal control, and performing such other
procedures as we considered necessary in the circumstances. We believe that our audit provides
a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the
supervision of, the company’s principal executive and principal financial officers, or persons
Khanh Chau - AC555 – Washington Mutual 29
30. performing similar functions, and effected by the company’s board of directors, management and
other personnel to provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance with generally
accepted accounting principles. A company’s internal control over financial reporting includes
those policies and procedures that (1) pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and dispositions of the assets of the company;
(2) provide reasonable assurance that transactions are recorded as necessary to permit
preparation of financial statements in accordance with generally accepted accounting principles,
and that receipts and expenditures of the company are being made only in accordance with
authorizations of management and directors of the company; and (3) provide reasonable
assurance regarding prevention or timely detection of unauthorized acquisition, use or
disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the
possibility of collusion or improper management override of controls, material misstatements
due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any
evaluation of the effectiveness of the internal control over financial reporting to future periods
are subject to the risk that the controls may become inadequate because of changes in conditions,
or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that the Company maintained effective internal control
over financial reporting as of December 31, 2005, is fairly stated, in all material respects, based
on the criteria established in Internal Control – Integrated Framework issued by the Committee
of Sponsoring Organizations of the Treadway Commission. Also, in our opinion, the Company
maintained, in all material respects, effective internal control over financial reporting as of
Khanh Chau - AC555 – Washington Mutual 30
31. December 31, 2005, based on the criteria established in Internal Control – Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have also audited, in accordance with the standards of the PCAOB, the consolidated
financial statements as of and for the year ended December 31, 2005 of the Company, and our
report dated March 8, 2006, expressed an unqualified opinion on those consolidated financial
statements.
/s/ Deloitte & Touche LLP
Seattle, Washington
March 8, 2006
Khanh Chau - AC555 – Washington Mutual 31
32. REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Shareholders of
Washington Mutual, Inc.
We have audited the accompanying consolidated statements of financial condition of
Washington Mutual, Inc. and subsidiaries (the “Company”) as of December 31, 2005 and 2004,
and the related consolidated statements of income, stockholders’ equity and comprehensive
income, and of cash flows for each of the three years in the period ended December 31, 2005.
These consolidated financial statements are the responsibility of the Company’s management.
Our responsibility is to express an opinion on these consolidated financial statements based on
our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting
Oversight Board (United States) (“PCAOB”). Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence supporting the
amounts and disclosures in the consolidated financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all material respects, the
financial position of the Company as of December 31, 2005 and 2004, and the results of its
operations and its cash flows for each of the three years in the period ended December 31, 2005,
in conformity with accounting principles generally accepted in the United States of America.
Khanh Chau - AC555 – Washington Mutual 32
33. We have also audited, in accordance with the standards of the PCAOB, the effectiveness of the
Company’s internal control over financial reporting as of December 31, 2005, based on the
criteria established in Internal Control – Integrated Framework issued by the Committee of
Sponsoring Organizations of the Treadway Commission, and our report dated March 8, 2006,
expressed an unqualified opinion on management’s assessment of the effectiveness of the
Company’s internal control over financial reporting and an unqualified opinion on the
effectiveness of the Company’s internal control over financial reporting.
/s/ Deloitte & Touche LLP
Seattle, Washington
March 8, 2006 (August 4, 2006 as to the effects of restatement discussed in Note 2)
Khanh Chau - AC555 – Washington Mutual 33