Banking Regulator Played Advocate Over Enforcer

The proposal languished until September 2006, when it was swiftly finalized after a congressional committee began making inquiries.

The long delay in issuing the guidance allowed companies to keep making billions of dollars in loans without verifying that borrowers could afford them. One of the largest banks, Countrywide Financial, said in an investor presentation after the guidance was released that most of the borrowers who received loans in the previous two years would not have qualified under the new standards. Countrywide said it would have refused 89 percent of its 2006 borrowers and 83 percent of its 2005 borrowers. That represents $138 billion in mortgage loans the company would not have made if regulators had acted sooner.

Risks Ran Rampant

Even after the guidance was issued, some banks interpreted it as permission to maintain old habits because the regulatory agencies had stopped short of issuing a binding rule.

Washington Mutual, for instance, said in a December 2006 securities filing that it was continuing to qualify borrowers based on their ability to afford a teaser interest rate. In August 2007, the bank was still qualifying borrowers at a 2 percent teaser rate instead of the full rate of 5 percent or higher they would eventually face, according to a shareholders' lawsuit filed by Bernstein Litowitz Berger & Grossmann.

As early as 2003, the company set up credit risk teams at more than a dozen offices around the country to assess the growing flood of applications for option ARM loans. The basic job was to "make exceptions" to the bank's standards so loans could be approved, said Dorothea Larkin, a former Washington Mutual credit risk manager and a witness in the Bernstein Litowitz suit.

"As we kept making the same exception over and over again, what was an exception in 2003 and in 2004 became the norm in 2005," Larkin said in an interview.

It was clear to some Washington Mutual employees that the company was making loans that borrowers could not afford and that the bank could suffer as a result. In 2005, a small group of senior risk managers drew up a plan that would have required loan officers to document that borrowers could afford the full monthly payment on option ARM loans.

The plan was shared with OTS examiners, according to a former bank official who spoke on condition of anonymity because the bank's practices are the focus of a federal investigation as well as several lawsuits.

"We laid it out to the regulators. They bought into it. They supported it," the former official said. But when a new executive team at the bank nixed the plan, the former official said, "the OTS never said anything."

In addition to taking more risks, Washington Mutual was setting aside a smaller share of revenue to cover future losses. The reserves had steadily declined relative to new loans since 2002. By June 2005, the bank held $45 to cover losses on every $10,000 in outstanding loans, according to financial records filed with federal regulators. Average reserves at OTS-regulated institutions had declined by about a third since June 2002, but Washington Mutual's reserves had fallen even further. They were 25 percent lower than the average for OTS-regulated thrifts.

OTS did not force the company to address the problem with reserves, though agency examiners worked full-time inside Washington Mutual's Seattle headquarters.

Polakoff said OTS closely monitored the company's allowance for loan losses and considered it sufficient. "They had good models in place calculating expected losses on the loan portfolio," he said.