Accusing the top executives of Washington Mutual of gross negligence in the nation's largest bank failure undoubtedly plays well among the many people hurt by its collapse.
But the lawsuit filed last month by federal regulators against former WaMu Chief Executive Officer Kerry Killinger and two of his lieutenants could face a long, difficult slog in court, some attorneys say.
"There are a lot of scalp-hunters in the public that would like to see these three from WaMu get skinned," said Jeffrey Tisdale, a Los Angeles lawyer defending executives of another failed bank who face a Federal Deposit Insurance Corp. (FDIC) negligence claim.
He counters that "it's not like the regulators didn't know what kinds of loans were being made ... I think the FDIC has got problems with its case."
But a former FDIC lawyer says he's heard the blame-it-on-lax-regulators argument before.
"That defense has been shot down many times," said retired FDIC deputy counsel Jack Smith, who oversaw the agency's lawsuits in the 1980s and '90s against executives at failed savings-and-loans. "You can't blame the policeman for not stopping you."
Regulators seized WaMu's banking operations in September 2008 and sold its assets to JPMorgan Chase for $1.9 billion. Shareholders were wiped out, and thousands of WaMu employees were laid off.
The FDIC says WaMu's failure and sale came at no cost to its deposit-insurance fund. But as receiver for the failed bank, the agency is entitled to sue the former directors and officers if it believes WaMu was harmed by their actions. Moneys recovered would help settle claims by the bank's creditors.
Unlike the shareholders and others who've sued WaMu and its former management, the FDIC has the benefit of deep pockets and access to all of WaMu's records.
"You find smoking guns oftentimes, and they improve your case," said Smith, who teaches at George Washington University's law school.
Kevin LaCroix, an Ohio attorney who tracks such lawsuits on his "D&O Diary" blog, said the FDIC will have to show the executives failed to exercise "appropriate care" in their duties.
"Did (the WaMu executives) see a housing bubble?" LaCroix asked. In pursuit of profits, "did they drive through a stoplight, or even a yellow light?"
The FDIC says the executives did. Its 63-page lawsuit, filed March 16 in federal court in Seattle, is the highest-profile case filed so far by the agency against former bank officers and directors following the recent financial crisis.
Washington Mutual is the biggest of the roughly 350 banks that have failed since 2008. The FDIC has said it plans to sue 158 former directors and officers and seek at least $3.57 billion in damages. The FDIC has sent letters to them demanding they pay millions of dollars to satisfy negligence claims — or face litigation. It has filed only six lawsuits so far.
We're all sitting here, waiting," Tisdale said.
None of the six lawsuits has been tried or settled. Kirby Behre, a Washington, D.C., attorney who represents sued executives, says the new wave of FDIC negligence lawsuits against directors of failed banks will be tough to prove.
"They (the FDIC) are on very, very thin ice," he said. "Nobody, not even the Fed or Treasury, in any way predicted a cataclysmic event as we saw a few years ago."
Although both sides in the WaMu lawsuits have staked out aggressive positions, outside attorneys from all perspectives agree the vast majority of such cases are settled before going to trial.
One unique aspect of the WaMu suit: It's the only one in the new crop of lawsuits where the FDIC asked to freeze executives' personal assets — those of Killinger and Stephen Rotella, WaMu's former chief operating officer.
The agency alleges they tried to "hinder, delay or defraud" their creditors by transferring money and property to their wives and into irrevocable trusts.
"That's grotesquely misleading and grotesquely unfair," said Barry Ostrager, a New York attorney who represents Rotella. Ostrager called the asset transfers "ordinary family planning."
Naming the two wives makes the case "more sensational" but "is not something one expects a government agency acting responsibly to do," he added.
Reckless conduct alleged
The complaint filed by the FDIC casts Killinger as a greedy banker who ignored risks he was well aware of, instead catering to Wall Street's expectations for rapid growth. Rotella and David Schneider, former chief of WaMu's home-loans division, are portrayed as subordinates enthusiastically carrying out the architect's plans.
The suit says they "gambled billions of dollars" and pursued a high-volume lending strategy that rewarded them financially, but they disregarded warnings by regulators and internal risk officers.
The FDIC cites internal correspondence that indicates Killinger saw the housing bubble years before the collapse.
In a March 2005 email to WaMu's top risk officer, Killinger wrote, "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."
Yet instead of pulling back from riskier loans, Killinger advocated the bank take on even more credit risk, according to the suit.
The executives ignored guidance from federal regulators as early as 2005 about managing inherently risky loan products such as option ARMs (adjustable-rate mortgages initially offering low minimum payments) and other nontraditional loans, the FDIC alleges.
Regulators told banks that made nontraditional loans to avoid piling on more risk with stated-income or low-documentation loans, loans to borrowers with high debt-to-income ratios, and loans to speculators and second-home buyers with little equity in the property, according to the lawsuit.
But Rotella, who was aware of the bank's increasing exposure to such loans, chose to strip the bank's central risk-management group of its independence and neglected to fix known weaknesses in the bank's technology for monitoring credit risks and fraud, the FDIC alleges.
WaMu's top risk officer told superiors the level of high-risk loans in its portfolio was worrisome: "A severe 'twin shock' of sustained housing price decline and rising interest rates could cause a 3x increase in mortgage charge-offs," he wrote in a report cited in the lawsuit.
Killinger nonetheless said he wanted the bank to pursue more such loans with "good underwriting and monitoring processes and controls" — partly because Wall Street rewarded companies taking on greater credit risk, the FDIC lawsuit alleges.
By the end of 2006, nonperforming loans in WaMu's subprime-mortgage portfolio had nearly quadrupled compared with a year earlier, the lawsuit alleges.
Still, it claims, in early 2007 Schneider asked his national subprime production manager how soon WaMu could "double" its subprime-loan business.
Even as the executives recognized the run-up in home values was unsustainable, WaMu wrote $42 billion in new option ARMs in 2006 and $24 billion in 2007, the FDIC says.
By September 2008, the FDIC says, WaMu carried more than $51 billion in option ARMs, accounting for nearly half its prime single-family loan portfolio.
Defense pokes holes
Defense attorneys for the former executives say the FDIC is attacking them with the benefit of hindsight.
"The reality is, all (three) worked to significantly reduce Washington Mutual's exposure," said Ostrager, the attorney for Rotella and Schneider. According to Rotella, WaMu sharply cut back on writing option-ARM loans after 2005.
In a statement, Killinger said WaMu's loan portfolio "reflected a proper and good-faith business judgment balance between continued U.S. government initiatives to extend mortgage loans to the underserved, while at the same time preserving the safety and soundness of the Bank."
His attorneys did not respond to requests for comment. The three executives have not formally answered the lawsuit in court yet.
Defense attorney Ostrager said the federal watchdog agencies — including WaMu's primary regulator, the Office of Thrift Supervision (OTS) — may have issued some warnings, but they didn't take enforcement actions against WaMu until it was too late.
"If what the individuals were doing was grossly negligent, why didn't anyone at OTS or FDIC say anything in 2005, 2006, 2007 or 2008 when they were on the premises?" Ostrager asked. "I think it's a showstopper," he said.
Indeed, a subsequent report from the FDIC's inspector general concluded that while OTS examiners "identified numerous concerns with WaMu's high-risk lending strategy," the regulator's headquarters rated the bank satisfactory "until WaMu began encountering significant financial losses in 2008."
Following criticism it was too cozy with the troubled financial institutions it was overseeing, the OTS was abolished and folded into another agency under last year's Dodd-Frank financial-reform legislation.
Tisdale said that could play to the defendants' advantage before a jury.
OTS "was parked in WaMu's headquarters all along. If they thought these option ARMs were risky and doomed for failure, they should have said something," he said.
Personal assets sought
In discussions before filing the lawsuit, the FDIC sought more than $900 million from Killinger and the other two former executives, according to a person familiar with the matter. The lawsuit doesn't specify the damages sought.
Behre, who is defending two former officers of IndyMac Bank, says individuals sued by the FDIC rarely have pockets deep enough to pay what the agency seeks in damages.
"All of these cases are filed against individuals for one reason, and that is to access insurance money," Behre said. "These individuals become pawns in a larger game of getting access to insurance coverage when the bank that has failed and is in trouble has no assets."
But especially in the WaMu case, any potential insurance proceeds are being eroded by legal defense costs in multiple lawsuits, including shareholder class-action suits.
"I don't think there's any chance" WaMu had $900 million in liability insurance for directors and officers, said attorney and blogger LaCroix, who runs Oakbridge Insurance Services, a specialty insurance broker. The federal government recovered $4.5 billion from 1990 to 1995 from claims connected to the savings-and-loan crisis. About $1.3 billion came from claims against former bank directors and officers, according to the FDIC.
Even if the FDIC recovers only a fraction of the alleged losses at banks in the recent financial collapse, retired FDIC attorney Smith said its lawsuit also reminds all bankers the agency can hold them accountable.
"Everybody who takes on a job as a director needs to take it seriously," he said. "I think a lot of them didn't."
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