Financial 'Reform' Dodges Big Lessons

As congressional partisans wrangle over financial reform, neither side is grappling with a fundamental lesson learned from an investigation into the causes of the financial crisis.

A recent Senate inquiry offered a rare peek into the secret world of bank examiners. What it revealed was that regulators had stopped regulating.

In the case of Washington Mutual, regulators found all sorts of trouble, from lax lending standards to high delinquency rates on loans, and yet failed to prevent the biggest bank failure in history.

Starting in 2003, examiners for the Office of Thrift Supervision found 545 problems at the bank. But the agency left it up to WaMu to track its own compliance with examiners' recommendations, and took no formal action against the bank until it was too late.

Even when problems grew so severe that the OTS should have taken strong enforcement action -- and let the public know -- the agency did nothing. In a revealing e-mail to WaMu's CEO, Kerry Killinger, agency director John Reich said of OTS' failure to demand remedies that "if someone were looking over our shoulders, they would probably be surprised."

A central lesson from the failure of Washington Mutual was that a system set up to prevent what happened utterly failed. For all the talk of reform, Congress isn't addressing the problem of regulators who fail to do their job.

Regulators routinely deferred to bankers and market forces and engaged in petty squabbles over who had authority over the bank. So the question now is: Can Congress fix ineffective regulators themselves?

"It's not only feeble enforcement, it is pitiful enforcement," Sen. Carl Levin, (D-Mich.), chairman of the subcommittee on permanent investigations said at an April 16 hearing when scolding Reich, who has since retired from the OTS.

In a bipartisan moment, Sen. Tom Coburn (R-Okla.) took it even further.

"I have concluded that investors would have been better off had there been no OTS," Coburn said. "OTS said everything was fine when, in fact, OTS knew everything wasn't fine and wasn't getting it changed."

'Conflict of Interest'

OTS's own fortunes were heavily tied to Washington Mutual's. The bank paid fees that amounted to 15 percent of OTS's budget - more than any other financial institution under its watch. So it was in the OTS's interest to make sure WaMu survived as a thrift, a bank that specializes in home mortgages.

The financial reform bill emerging in Congress would fold the function of OTS into another agency that oversees national banks, the Office of the Comptroller of the Currency. That would eliminate a practice in which some banks could pick and chose their regulator.

But as Coburn pointed out it an interview with the Investigative Fund, the reform bill still would compel regulators to depend on the banks they supervise for revenue.

"They haven't addressed that issue" in the financial reform bill, Coburn noted. "You have to end that conflict of interest."

Another issue highlighted by the Senate subcommittee investigation was deference to the market to regulate. Emails and reports turned up in that investigation show regulators would allow unsafe practices as long as shareholders and investors were happy.

For example, an OTS examiner wrote in an e-mail to his boss in 2005 - three years before WaMu's collapse -- that he had problems with WaMu's lax lending standards, because it could lead to bad loans. Yet, he added that as long as WaMu was profitable, "it has been hard for us to justify doing much more than constantly nagging (okay, "chastising") ... since they have not been really adversely impacted in terms of losses."

The reluctance to tell bank executives what to do so long as they reported profits came despite examiners' own concerns in that year that a booming housing market was "masking" potential losses from shoddy loans -- what would have been the first signs of a coming mortgage meltdown and financial crisis, and key opportunities to prevent it.

Persistent 'Liars' Loans'

An easy target of the hearing was stated-income loans, mortgages that didn't require borrowers to show proof of their income. Within the industry, these became known as "liars' loans" because income could so easily be fabricated.

Regulators knew about liars' loans, and the trouble that might ensue. But they permitted them. In private emails, OTS' chief examiner overseeing WaMu called stated-income loans "a flawed product that can't be fixed and never should have been allowed in the first place."

Regulators could have banned stated-income loans. Reich said he didn't because bankers persuaded him that stated-income loans performed no worse than other loans. But stated-income loans became an invitation for fraud and led to high default rates. What's more, stated-income loans were once used sparingly but during the mortgage frenzy, 90 percent of Washington Mutual's home-equity loans and more than 50 percent of its subprime loans were stated income.

Now that the world knows that stated-income loans are shoddy loans have regulators gotten rid of them?

"They certainly are frowned-upon," testified FDIC examiner George Doerr. "There's nothing to prevent them in the rules today."

FDIC chair Sheila Bair said she wouldn't oppose getting rid of them. But she hasn't. The problem, she says, is that if you forbid federally insured banks from giving loans to people who can't document their income, they could lose business to unregulated lenders. So fears about regulations putting banks at a competitive disadvantage remain strong even in the wake of the financial crisis.

Regulators did ban stated-income loans for subprime loans. But that was in late June 2007, just as Wall Street was shutting down the subprime market completely. Investors refused to buy the bad loans anymore. And banks refused to make them and hang onto them. In that case, the market took stronger action than the regulators.

In 2006 when regulators issued a new "guidance," urging banks to make sure borrowers could repay high-risk loans before approving them, OTS ignored the guidance for a year because Washington Mutual argued it was going to lose business as a result.

Some in Congress aren't sure how to address this problem.

"The culture of regulators driven by heir ideology is a very tough one to legislate around," said Steve Adamske, spokesman for the House Financial Service Committee .

Sen. Sherrod Brown, D-Ohio, said, "You can't always count on the regulators, especially in the administration like the one before this one. So we need more teeth in the bill."

No Room for a Rival

While regulators treated Washington Mutual with kid gloves, they put on boxing gloves when dealing with each other.

While the OTS had an interest in keeping Washington Mutual alive for its fees, the FDIC ultimately had an interest in making sure Washington Mutual was sold before it had a chance to fail.

The FDIC would have to pay for Washington Mutual's losses if the bank failed outright, and Washington Mutual was big enough to wipe out the FDIC's insurance fund. An FDIC analysis determined that WaMu's demise would have wiped out $41 billion of the insurance fund's $45 billion.

While rivalries between banking agencies are well-documented, these competing interests sometimes played themselves out in juvenile stunts.

The FDIC was the "backup regulator" of Washington Mutual but still had a dedicated examiner assigned to the bank. Even so, for four months in 2007, the OTS as primary regulator wouldn't give the FDIC examiner a chair or a desk in the library where WaMu kept its records for inspection by regulators.

When Senate investigators privately asked an unidentified senior FDIC official why the agency wasn't tougher and had failed to take action on its own, the official said such behavior would be viewed by other regulators as an "act of war" and could hurt relationships among agencies.

That was precisely the atmosphere in early August 2008, when Bair asked Reich, her counterpart at OTS, about discreetly checking with other banks to see if they'd be willing to buy WaMu whole after a seizure. There had already been a run on the bank.

This set Reich off, who lectured Bair in an e-mail, "I should not have to remind you the FDIC has no role until the (OTS) rules on solvency...You personally, and the FDIC as an agency, would likely create added instability if you pursue what I strongly believe would be a precipitous and unprecedented action."

Reich threatened to expose Bair publicly. But weeks later, with WaMu on the verge of running out of cash, the OTS concurred with Bair and WaMu was sold to JP Morgan Chase.

And now? This same sort of agency rivalry could show up in a reformed system. The Senate bill creates a "bureau" of consumer financial protection to prevent predatory lending practices. But the bureau, a political hot potato, is given limited power to make rules.

For example, any member of a special oversight council, which includes other regulators, can temporarily set aside the bureau's rules and the council can overrule them with a two-thirds vote.

The bureau is even required to coordinate its examinations with those of other regulators, even state regulators. And if the findings conflict with the other regulator, the banks can force the two regulators to issue a joint decision.

The hearings, which followed an 18-month investigation, left Levin puzzled as to what to do. If regulators can't pass tough regulations, should Congress do it for them? Do we need a law, he asked, to outlaw stated income loans and to require banks to make loans only to people who can afford to repay them?

But those are just some of the questions. Coburn alluded to the other, huge one: Even if Congress passes a financial reform law, will regulators, operating in their secret world, fail to enforce it? Congress should have been watching the regulators more closely, he said.

Maybe right now, he added, more needs to be learned about what went wrong behind the scenes -- and how to really fix it.

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