Washington Mutual Bank's Collapse Under An Audit Perspective

Keller Graduate School of Management

Devry University

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WASHINGTON MUTUAL'S COLLAPSE

under an audit perspectiveAC 555 - EXTERNAL AUDTITING

Instructor: Senior Professor Ted Tully

Student: Khanh Chau

February 2009

San Jose Center

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Khanh Chau - AC555 – Washington Mutual 2

Index

I. PrefixII. IntroductionIII. Washington Mutual Inc.

1. Washington Mutual Bank profile2. Key personnel

IV. Washington Mutual Bank's problems1. The Power of Yes2. Wal-Mart banking3. Referral fees for loans4. Inflating property value5. ARMs – Adjustable rate mortgage6. No income verification

V. What make Washington Mutual Bank collapse?1. Mortgage crisis2. Changing business strategy3. Negative financial outlook – Increasing loss reserves4. Government regulatory – Red flag5. Public’s high pressure – The boiler6. Massive outflows – Depletion7. Receivership

VI. The auditors: Deloitte1. Where were the auditors2. Was Deloitte aware of financial problems that WaMu faced?3. What should Deloitte have done?

VII. ConsequencesVIII. ConclusionsIX. Appendixes

1. Washington Mutual Bank 's financial statements 2005-2007 (abstract)2. Disclosures of contingent credit risk liabilities3. Deloitte's auditor reports

X. References


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


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.


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


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


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].


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


[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.


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].


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


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.


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


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 15th, 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


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


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.


Table 1- Financial ratios analysis - Washington Mutual's performance and financial health

Financial ratios Unit Dec 07 Dec 06 Dec 05 NoteLiquidity

Current ratio % 0.084 0.082 0.091Negative working capital andextremely low current ratio,current cash debt coverageratios are ALL IN RED, thatindicated an unfavorableliquidity to meet obligations orunexpected urgent cash needs.

Working capital $ mio (230,848) (252,352) (258,694)

Current cash debtcoverage ratio

Times 0.031 0.026 0.006

Solvency

Debt to total assetsratios DA % 0.925 0.922 0.921 Very low ratios of cash debt

coverage ratios and free cashflow available to totalliabilities ratios indicated thecompany unfavorable solvencyand incapability to meet theobligations in a long run.

Cash debt coverageratios Times 0.025 0.023 0.006

Free cash flow $ mio 5,431 4,842 (551)Free cashflow/current liabilities % 0.022 0.018 (0.002)

Management efficiency

Net Profit Margin % -- 13% 16%All weak ratios indicated thecompany poor salesperformance from each dollarinvested in assets or equity,and the management’sineffective in using itsresources to generate sales.

Return on asset ROA % (0.000) 0.010 0.010

Return on equity ROE (0.003) 0.131 0.126

With a little research of

industry and financial risk

indicator, the auditors can easily

identify the client business risks.


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®IMPACT

TOP ISSUE

Corporate Governance Events -49.35 Avg Ratio of Incentive to Annual Comp ofCEO & 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


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


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


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


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


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.


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.


IX. APPENDIXES

APPENDIX 1 – WASHINGTON MUTUAL INC – FINANCIAL STATEMENTSTable 2- Washington Mutual, Inc. - Income statements 2005 – 2007Source of Hoovers.com.proxy.devryu.edu [20]

($ mio) Dec 07 Dec 06 Dec 05Revenue 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 3432Net Profit Margin -- 13.40% 15.80%

Table 3 - Washington Mutual, Inc. - Statement of cash flow - 2005-2007Source of Hoovers.com.proxy.devryu.edu [20]

Dec 07 Dec 06 Dec 05Net 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


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 EquityAccounts 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 EquityPreferred Stock Equity 3,392 492 --

Common Stock Equity 21,192 26,477 27,279

Total Equity 24,584 26,969 27,279Shares Outstanding (mil.) 113 113 113

Table 5 - Historical FinancialsSource of Hoovers.com.proxy.devryu.edu [20]

Year AssetsNet

Income Income as Employees

($ mil.) ($ mil.)% of

AssetsDec 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


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 strengthLiquidity Dec 08 Dec 07 Dec 06 Dec 05Current ratio 0.08 0.08 0.09

Total Current Assets 21,081 22,632 25,857


Working capital -230,848 -252,352 -258,694Current cash debt coverage ratio 0.03 0.03 0.01

Net Operating Cash Flow 7,697 7,269 1,765


Solvency Dec 08 Dec 07 Dec 06 Dec 05Debt to total assets ratios DA 0.93 0.92 0.92


Total Assets 327,913 346,288 343,573

Cash debt coverage ratios 0.03 0.02 0.01



Free cash flow 5,431 4,842 -551


Capital Expenditures -321 -441 -607

Cash Dividends Paid -1,945 -1,986 -1,709

II. Profitability Dec 08 Dec 07 Dec 06 Dec 05Asset 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 5.83Net income -67 3,558 3,432

Total Assets 327,913 346,288 343,573

Return on Assets - 5 Yr. Avg. 0.81 0.53 6.22ROE (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 11.59Total 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


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”


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


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


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


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.


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, WashingtonMarch 8, 2006 (August 4, 2006 as to the effects of restatement discussed in Note 2)


X. REFERENCES

1. http://www.nytimes.com/2008/12/28/business/28wamu.html?hp=&pagewanted=all2. Office of Thrift Supervision FACT SHEET OTS3. http://www.reuters.com/finance/stocks/chart?symbol=WAMUQ.PK4. http://www.npr.org/templates/story/story.php?storyId=951051125. http://online.wsj.com/article/SB122238415586576687.html6. http://www.fool.com/investing/dividends-income/2008/01/14/worst-stock-for-2008-washington-mutual.aspx7. http://finance.pro2net.com/x63579.xml8. http://www.sec.gov/Archives/edgar/data/933136/000110465906053228/a06-17516_110ka.htm#ExhibitsFinancialStatementSchedul_1846239. http://en.wikipedia.org/wiki/Kerry_Killinger10. http://en.wikipedia.org/wiki/Subprime_lending11. http://en.wikipedia.org/wiki/United_States_housing_bubble12. http://www.pr-inside.com/washington-mutual-shareholders-have-banded-r892883.htm13. http://www.lawyersandsettlements.com/features/wamu-appraisal-securities-fraud.html14. http://www.bizjournals.com/seattle/stories/2008/10/13/story9.html15. http://choosingdemocracy.blogspot.com/2008/12/how-finance-capital-created-economic.html16. http://finapps.forbes.com/finapps/AccountingRisk.do?tkr=wm17. http://investing.businessweek.com/research/stocks/private/snapshot.asp?privcapId=9844618. http://www.lawyersandsettlements.com/features/washington_mutual_angry.html19. http://seattlepi.nwsource.com/business/398621_wamu04.html20.http://premium.hoovers.com.proxy.devry.edu/subscribe/tools/report/builder/report.xhtml?ID=ffffrhrrsxkxfcjfjs&country_id=76&Sections[]=4&Sections[]=6&Sections[]=7&Sections[]=8&Sections[]=10&Sections[]=11&Sections[]=12&Sections[]=13&Sections[]=17&Format=HTML&Build.x=22&Build.y=621. Washington Mutual annual report 200522. http://www.brookings.edu/papers/2007/10_mortgage_industry_downs.aspx

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Washington Mutual Bank's Collapse Under An Audit Perspective