Regulator Failed to Rein In Banks' Risky Practices

When Countrywide Financial felt pressured by federal agencies charged with overseeing it, executives at the giant mortgage lender simply switched regulators in the spring of 2007.

James Gilleran, former director of the Office of Thrift Supervision, said the agency's goal is to "allow thrifts to operate with a wide breadth of freedom from regulatory intrusion." (By Michael Springer -- Bloomberg News)

The benefits were clear: Countrywide's new regulator, the Office of Thrift Supervision, promised more flexible oversight of issues related to the bank's mortgage lending. For OTS, which depends on fees paid by banks it regulates and competes with other regulators to land the largest financial firms, Countrywide was a lucrative catch.

But OTS was not an effective regulator. This year, the government has seized three of the largest institutions regulated by OTS, including IndyMac Bancorp, Washington Mutual -- the largest bank in U.S. history to go bust -- and on Friday evening, Downey Savings and Loan Association. The total assets of the OTS thrifts to fail this year: $355.7 billion. Three others were forced to sell to avoid failure, including Countrywide.

In the parade of regulators that missed signals or made decisions they came to regret on the road to the current financial crisis, the Office of Thrift Supervision stands out.

OTS is responsible for regulating thrifts, also known as savings and loans, which focus on mortgage lending. As the banks under OTS supervision expanded high-risk lending, the agency failed to rein in their destructive excesses despite clear evidence of mounting problems, according to banking officials and a review of financial documents.

Instead, OTS adopted an aggressively deregulatory stance toward the mortgage lenders it regulated. It allowed the reserves the banks held as a buffer against losses to dwindle to a historic low. When the housing market turned downward, the thrifts were left vulnerable. As borrowers defaulted on loans, the companies were unable to replace the money they had expected to collect.

The decline and fall of these thrifts further rattled a shaky economy, making it harder and more expensive for people to get mortgages and disrupting businesses that relied on the banks for loans. Although federal insurance covered the deposits, investors lost money, employees lost jobs and the public lost faith in financial institutions.

As Congress and the incoming Obama administration prepare to revamp federal financial oversight, the collapse of the thrift industry offers a lesson in how regulation can fail. It happened over several years, a product of the regulator's overly close identification with its banks, which it referred to as "customers," and of the agency managers' appetite for deregulation, new lending products and expanded homeownership sometimes at the expense of traditional oversight. Tough measures, like tighter lending standards, were not employed until after borrowers began defaulting in large numbers.

The agency championed the thrift industry's growth during the housing boom and called programs that extended mortgages to previously unqualified borrowers as "innovations." In 2004, the year that risky loans called option adjustable-rate mortgages took off, then-OTS director James Gilleran lauded the banks for their role in providing home loans. "Our goal is to allow thrifts to operate with a wide breadth of freedom from regulatory intrusion," he said in a speech.

At the same time, the agency allowed the banks to project minimal losses and, as a result, reduce the share of revenue they were setting aside to cover them. By September 2006, when the housing market began declining, the capital reserves held by OTS-regulated firms had declined to their lowest level in two decades, less than a third of their historical average, according to financial records.

Scott M. Polakoff, the agency's senior deputy director, said OTS had closely monitored allowances for loan losses and considered them sufficient, but added that the actual losses exceeded what reasonably could have been expected.

"Are banks going to fail when events occur well beyond the confines of reasonable expectation or modeling? The answer is yes," he said in an interview.