06/14/2010 05:12 am ET | Updated May 25, 2011

Was Bernie Madoff the Exception or the Rule?

Were the big banks all knowingly running Ponzi schemes? That's the question that arises from the stunning hearings held this week by the Senate Permanent Committee on Investigations, chaired by Senator Carl Levin, on the collapse of Washington Mutual, the largest thrift failure in the U.S. Faced with looking like fools or knaves, the barons of the big banks -- from Robert Rubin to Lloyd Blankfein to WaMu's Kerry Killinger -- have chosen, not surprisingly, the fool. But the WaMu hearings -- and Zach Carter's stunning running commentary on them -- suggest that while Bernie Madoff may have been the extreme, he wasn't the exception. (Note: Carter blogs for the Campaign for America's Future which I co-direct)

The Levin hearings show that WaMu systematically peddled loans to people it knew could not pay them back. This wasn't an accident. Levin exposed a WaMu internal audit that reviewed 132 loans, and found 115 involved confirmed fraud, with 80 having "unreasonable" income -- meaning the income listed on the loan was so preposterous that any reasonable person, much less a trained loan officer, would have called it into question. The audit resulted in no -- zero, nada -- changes in WaMu's lending practices. Fraud wasn't a problem; it was the business plan.

As Carter summarizes:

According to the FBI, 80% of mortgage fraud is committed by the lender. We're not talking about stupid loan officers allowing borrowers to get away with something crazy that is bad for the bank. We're talking about clever loan officers pushing fraudulent documents in order to score bigger paychecks, and bank executives looking the other way so that they can keep getting big paychecks from the securitization machine. This isn't a problem unique to WaMu. This is how the U.S. mortgage system operated for half a decade.

WaMu particularly pushed predatory option-ARM loans, loans with an initial monthly payment so low that it often didn't even pay off the interest on the loan. Then after a couple of years, the monthly payment explodes -- and the loan becomes unaffordable.

WaMu actively trained its personnel to convince skeptical borrowers to take these loans because option-ARMS received a very high yield when packaged into securities. So WaMu's compensation schemes rewarded loan officers for the number of loans sold, not the quality of the loans. Stunningly, Levin cited internal memos showing that even loan officers under investigation for fraud were rewarded with trips to Hawaii and the Bahamas for their high production.

WaMu packaged the fraudulent loans into securities and sold them to investors, or peddled the loans to investment banks that did the same. Even after WaMu's own internal audits reported that a high percentage of the loans were fraudulent, WaMu still sold them to investors. Worse, even after WaMu's own study showed that the default rates on option-ARMS were going to be staggering, WaMu rushed to peddle even more of these loans to investors on an "urgent" basis. As Carter reports, "They not only packaged existing option-ARM loans into securities, they issued as many new option-ARMs as possible, in order to score securitization profits before the market collapsed." CEO Kerry Killinger testifies that he doesn't know if it would have been appropriate to tell investors what the company knew about default rates. "I don't know what actually happened," says Killinger.

As Carter summarizes, this was essentially a Ponzi scheme, similar to Madoff's:

Making truckloads of fraudulent loans can only end in disaster, but WaMu [executives weren't] really interested in the long-term picture. They were only interested in their ability to book these loans for big, short-term profits. Even when those bad loans finally took the company under, it had been, in a sense, a success. Its executives had already made millions.

WaMu's [executives were] in many ways operating a simple Ponzi scheme. Their risky loans were going bad, but the company was trying to counter those inevitable losses with the short-term profits from issuing more risky loans. That's basically how Bernie Madoff's scam worked, except he wasn't using make-believe loan profits, he was using make believe stock returns. So long as the bubble keeps growing, the scam could keep moving. But when the bubble burst, there was no way to keep issuing lots of loans in an economy where home prices were plunging.

The one divergence from the Ponzi scheme is securitization -- if WaMu could dump the bad loans off its books, then it wouldn't have to eat the inevitable losses. But that doesn't reflect well on WaMu-- it means [the executives] were deceiving and abusing investors.

Why run this scheme that would lead to the ruin of the bank? Because the executives were making out like, well, like bandits. Killinger, the CEO of WaMu, was taking home 11 to 20 million a year during the housing boom.

As Carter ponts out, what WaMu was doing in mortgages -- originating mortgages that they knew would default, cutting them up into securities, and marketing them to investors without notice -- isn't much different than what Goldman Sachs was doing in synthetic subprime CDOs -- creating securities that it knew would fail in order to bet against them, while selling them to investors without notice.

These guys weren't fools. They knew what they were doing. They knew that the music would stop someday, and the reckoning would come, or more likely, the Feds would step in and bail them out. (Amazingly Killinger is still outraged that WaMu wasn't bailed out rather than put out of business). But they kept dancing because they were cleaning up along the way.

In the last two weeks, the Financial Crisis Inquiry Commission and the Levin Hearings provide a stunning picture of the industry. The good cop, FCIC, treats the bankers as experts, listens to their opinions, and lets them claim the role of fools. "We didn't know." "We didn't realize housing prices wouldn't always go up". " We weren't responsible."

Then yesterday, the bad cop -- the Levin committee -- exposed the inner working of what Bill Black calls "control fraud," a business model based upon fraud as central to its profitable operations. It is hard to believe that WaMu or Madoff is an exception. Levin should probe every major bank engaged in the securitization of mortgages. Is it likely that their bank officers were fools? Or that they were prepared to turn their heads or hold their noses because the rewards were so great? Ignorance is their defense, not their condition. They knew what they were doing. The rest is for a prosecutor to sort out.