Oct. 26--Second of two parts

For decades, Washington Mutual lived up to its image as a staid, straight-laced Seattle institution. Its motto: "The Friend of the Family."

By the time WaMu made history last year as the nation's biggest bank failure, it bore no resemblance to this homey image.

What few people knew was that bank executives crafted a radical new business strategy in 2003 that was intended to boost profits. The new WaMu used huge sales commissions and misleading marketing to hawk risky and overpriced loans to borrowers.

In short, WaMu became one of the nation's biggest predatory lenders.

The strategy eventually failed, not only bringing down Washington Mutual but deceiving borrowers, costing thousands their homes.

In particular, the bank promoted as its "signature loan" a complex product known as the option ARM. This adjustable-rate mortgage, much like a credit card, gave borrowers the choice of making low minimum payments. But that option didn't cover the interest and only dug them deeper into debt.

WaMu and its brokers promoted this feature as a benefit for borrowers. Pay less on your mortgage and take that vacation you've always dreamed of.

WaMu lured borrowers with a very low interest rate of about 1 percent. But this "teaser" rate was good only for one month. After that, the option ARM could have far higher interest rates than conventional 30-year fixed-rate loans.

With each minimum payment, unpaid interest piled up. Once the debt grew too large, WaMu canceled the minimum-payment option. You could suddenly get a new bill for two or three times what you had been paying.

Another aspect of the option ARM made it even riskier. Washington Mutual broke the most basic rule of lending, a rule as fundamental as "all lifeguards must be able to swim":

It would give you an option ARM even if you couldn't afford to repay it. You only needed enough income to cover the minimum payments.

Regulators did nothing about it until years later.

Several other top lenders pushed the option ARM, as well, contributing to the mortgage crisis. The White House is pushing for a new consumer regulatory agency to end these sorts of abuses, but the banking lobby and even federal banking regulators are opposed. Banks say more regulation would kill innovation.

"I hated that loan," said Mary Kay Morse, a 20-year veteran at WaMu whose job was to persuade independent brokers to make option ARM loans. "It's just not a good loan. It wasn't good for the borrower."

That loan affected her opinion of WaMu.

"I always felt like I worked for a really honest industry that cared for the borrowers they dealt with," she said. The corporate culture changed to: "We just want to do the most we can to make money for the bank."

WaMu's new strategy

The strategy that eventually would destroy Washington Mutual and devastate so many of its borrowers was first presented publicly in a 487-seat auditorium in Manhattan's theater district on Dec. 9, 2003.

Chief Executive Officer Kerry Killinger stood before an audience of Wall Street professionals on "Investors Day" and spoke of the need for bold change.

"The environment that we are in today is more challenging than I have seen in several quarters," Killinger said, "and that's been particularly paramount in the mortgage space."

Common wisdom holds that the mortgage meltdown began in 2007. But in fact, serious trouble was brewing in 2003.

The Federal Reserve, led by Alan Greenspan, had aggressively cut interest rates starting in 2001 to calm the economic tremors of the dot-com bust and the Sept. 11 terrorist attacks.

Rates on 30-year loans, which had hovered around 7.5 percent, tumbled to 5.25 percent by June 2003. Americans pounced on the falling rates to buy new homes or refinance costlier loans. The massive surge in lending stoked Washington Mutual's profits.

July was a turning point. Rates began creeping up, sending borrowers scurrying to lock in before rates went higher. The mortgage market was peaking.

As demand waned, lenders tried to entice business by slashing profit margins on conventional mortgages, such as the 30-year fixed. WaMu's chief business was making home loans, yet it lost money on that segment in the third quarter of 2003.

By November, WaMu had eliminated 4,500 full-time jobs in home lending and ousted the division head. By year's end, its mortgage business had shrunk with alarming speed, down by about half from the summer.

After Killinger finished speaking, Chief Financial Officer Tom Casey got up and presented WaMu's solution.

WaMu had other types of loans, such as subprime and home-equity lines of credit, that remained highly profitable. He noted there was even a specialty loan for borrowers with good credit that remained lucrative, the option ARM.

As Casey explained it, the bank recently had beefed up its commissions and retrained its sales force to push option ARMs. In just the past few months, they had climbed from 15 to 35 percent of its mortgage business.

The loan -- mind-numbingly complex and highly risky for both the bank and its customers -- originally was created for the savviest and most risk-tolerant of borrowers.

When Casey took questions, none of these highly paid professionals asked an important question: Why would the average customer want a loan so risky, costly and hard to understand?

"I felt totally duped"

Usually, Bob Houk's wife handled the family's money matters. But after being diagnosed with a brain tumor, she was in and out of the hospital, so he took over.