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The AIG Scandal, Brought to You by Light Touch Regulation

ots.thumbnail.jpgThe Washington Post tells us that Scott Polakoff was placed on leave by the Office of Thrift Supervision (OTS), of which he is acting director. The apparent cause is an investigation into allegations that he was involved in an OTS scheme to allow IndyMac and other federal savings banks to falsify their financial statements. Maybe someone needs to look into the way OTS dealt with AIG.

The Office of Thrift Supervision is the functional regulator of AIG, including Banque AIG and AIGFP, the AIG subsidiaries directly responsible for the staggering losses in credit default swaps which led to the acquisition of AIG by unwilling US taxpayers. This happened because of the Gramm-Leach-Bliley Act. This bill, along with other Phil Gramm laws, was designed to gut regulatory practice by letting all financial services companies into all financial businesses. Regulation was to be done by function, so if a bank decided to get into selling securities, its securities business would be subject to regulation by SEC, while its banking business remained under its primary regulator. Each financial company would get a primary federal regulator, and the Fed acts as the consolidated or umbrella regulator.

The goal of this part of the dismantling of the New Deal regulatory structure was to encourage greater competition among financial companies in creating new financial products. It was an article of faith that these new products would benefit consumers.

In 1999, AIG formed a federal savings bank sub, and came under the functional supervision of the OTS. Then it formed Banque AIG in France, and opened an AIGFP office in London that included a branch of Banque AIG. The French banking regulator, the Commission Bancaire, recognized OTS as an equivalent regulator in 2003, and allowed it to be the lead regulator. Banque AIG has $234bn in regulatory arbitrage credit default swaps outstanding. These are CDSs which reduce the amount of capital European Banks must maintain. These are also the CDSs that AIG said might require collateral if executives at Banque AIG quit, which they did this week.

Polakoff recently testified (PDF) about his organization’s supervision of AIG. “OTS did not foresee the extent of the risk concentration and the profound systemic impact credit-default swap products caused within AIG….”  He said OTS should have directed the company to stop selling credit-default swaps before it quit on its own in December, 2005. At that point, he says, AIG had $80bn (p.5) in CDS commitments.

The pace of change and deterioration of the housing market outpaced our supervisory remediation measures for the company.

OTS took responsibility for comprehensive regulation of AIG in 2000. Polakoff’s written testimony doesn’t describe any regulation prior to late 2003, when “OTS embraced a more enterprise-wide approach to supervising conglomerates.” Meaning AIG. It was then that the Commission Bancaire recognized OTS as its equivalent regulator, and apparently left it to OTS to supervise AIG.

In 2005, OTS reviewed AIGFP and wrote a letter in March 2006, describing weaknesses in AIGFP’s “documentation of complex structures transactions, in policies and procedures regarding accounting, in stress testing, in communication of risk tolerances, and in the company’s outline of lines of authority, credit risk management and measurement.” OTS also criticized American General Finance, a consumer loan sub. OTS saw no progress on corrective measures. So it sent another nasty letter later that year.

In 2007 (isn’t this a short timeline?) OTS increased surveillance of AGF and AIGFP, as well as the federal savings bank that was its direct responsibility. And we get our first action, a supervisory agreement with the little bank.

A $128 million reserve was established to cover costs associated with providing affordable loans to borrowers whose creditworthiness was not adequately evaluated when their loan was originated and to reimburse borrowers who paid large broker fees or lender fees at the time of the origination.

The AIG sub was one of the mortgage companies originating the kind of loans that brought down the entire system.

OTS finally got around to actually doing something with AIG in March, 2008, apparently responding to the AIG 10-K admission of material weakness in managing its credit default swap portfolio. They asked for a plan of correction, wow, and sent it to AIG as a confidential communication. If AIG got a subpoena calling for production of this letter, it was to notify OTS.

The Fed is the umbrella supervisor of AIG, above OTS, even. What did it do? Nothing.

No wonder people refer to this as “light-touch” regulation. It sure looks like part of the regulatory race to the bottom, sponsored by the financial elites and the Republican Party.

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