SEATTLE — For decades, Washington Mutual lived up to its image as a staid, straightlaced 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. In fact, the bank had become one of the nation’s biggest predatory lenders.

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 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. 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.

How it started

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. Chief Financial Officer Tom Casey presented the bank’s solution.

Washington Mutual 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 percent to 35 percent of its mortgage business.

Bob Houk is one who fell victim to the complicated loans. Usually, his 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. In late 2006, he received a postcard with WaMu’s logo on it.

Houk already had a 30-year WaMu mortgage at a fixed rate of 4.6 percent. But the postcard promised to lower the monthly payments on their Bainbridge Island home with an adjustable- rate mortgage starting at only 1 percent interest.

A couple of months after signing up, Houk noticed something on his monthly statement that gave him a sick feeling. Instead of one low monthly payment, there were now options. His minimum monthly payment of only $1,018 was there. But there were also higher-priced options for paying interest only or for paying interest and principal. Just covering the interest that month would cost him about $1,000 more.

The 1 percent interest rate had reset to 7.4 percent, nearly 3 percentage points above Houk’s previous loan. This was buried in the fine print in a sheaf of legal documents he had signed.

“Who in their right mind would give up a 4.6 percent loan?” Houk said. “I felt totally duped.”

Commissions fueled it

Washington Mutual did not reward brokers for getting its customers the best deal. Just the opposite. The worse the terms were for borrowers, the more WaMu paid the brokers.

A WaMu daily rate sheet obtained by The Seattle Times shows how lavish the rewards could be. On an option ARM, WaMu would reward brokers as much as 3 percent of the loan amount — more than triple the standard commission at the time.

Brokers would get an additional point — 1 percent of the loan — for roughly every half-point in higher interest the borrower paid. So the broker would get 3 percent of the loan if he could get the borrower to pay 1.5 percent above the market rate.

The industry’s defense for the option ARM, even today, is that since home prices were rising so quickly then, borrowers could go deeper into debt and still come out ahead.

But the prospect of housing prices falling made the option ARM too risky for WaMu to keep on its own books because borrowers might default in large numbers. But, as Killinger explained, there was a solution: WaMu would continue to make the loans, but would bundle them into mortgage-backed securities and sell them to big investors. Soon, Washington Mutual was selling nearly all of its new option ARMs.

But by July 2007, across the industry, big investors became alarmed by how many borrowers were not paying off their loans, and stopped buying packages of option ARMs. Seemingly overnight, Washington Mutual got stuck with billions in risky loans it had intended to sell.

The number of bad loans on WaMu’s books soared, scaring big depositors whose accounts weren’t fully insured.

When WaMu went under, the bad option ARM loans in its portfolio had nearly quintupled in the last 12 months to $3.2 billion.

When a run on the bank ignited in September last year, regulators shut down Washington Mutual and sold its assets to JP Morgan Chase.