Treasury Inspector General: Regulators ‘Viewed Growth and Profitability’ As Evidence IndyMac Was Fine

ots.jpgYesterday, the Inspector General of the Treasury Department released a report showing that regulators at the Office of Thrift Supervision (OTS) — which is responsible for monitoring banks that specialize in mortgage lending — “repeatedly ignored warnings, including from their own employees, about the dangerous excesses at California mortgage lender IndyMac Bancorp.” The collapse of IndyMac last year cost the U.S. government about $10.7 billion.

According to the report, “OTS viewed growth and profitability as evidence that IndyMac management was capable”:

OTS identified numerous problems and risks, including the quantity and poor quality of nontraditional mortgage products. However, OTS did not take aggressive action to stop those practices from continuing to proliferate. OTS had at times as many as 40 bank examiners involved in the supervision of IndyMac; however, the examination results did not reflect the serious risks associated with IndyMac’s business model and practices.

In 2005, the OTS found that IndyMac “was having trouble with its cash flow,” but the office “did not issue any enforcement action, either informal or formal, until June 2008.” And this is not the first such tale to emerge; in October, the SEC’s Inspector General found similarly ignored warnings with regard to Bear Stearns before its federally financed collapse into the arms of J.P. Morgan. If nothing else then, the report underscores the desperate need for regulatory reform, in the wake of a Bush administration that “made it clear they planned to deliver less supervision over the financial services industry.” We all know the outcome of that deregulatory philosophy.

This week, President Barack Obama laid out his framework for regulatory reform. These reforms are still short on detail, but the most important could be the one aimed at ensuring that “companies cannot cherry-pick among competing regulators.” After all, in 2007, Countrywide Financial “simply switched regulators” to come under the more lax supervision of the OTS. Countrywide proceeded to go bust due to risky mortgages, and needed to be rescued by Bank of America. Allowing banks to shop around for the regulator they like best will inevitably lead to trouble, as the banks will settle on the regulator that is most in tune with their business interest.

Rep. Barney Frank (D-MA) has floated the idea of a “systemic risk regulator” — possibly the Federal Reserve — that would be charged with identifying risk that could topple the financial system. This could work, but waiting until risk is systemic to identify it means that risk large enough to endanger the system has been allowed to build up.

Instead, a focus on reforming the smaller agencies, like the OTS, the Commodity Futures Trading Commission, and others may be the key to a successful reform effort. But perhaps most important of all is this — Obama needs to appoint regulators who believe prudential oversight is important, something the Bush administration excelled at not doing.