Left Hand, Meet Right Hand

The government sues bankers over offenses government regulators once ignored.

Kerry Killinger, former CEO of Washington Mutual

A couple of weeks ago, the government started signaling, at long last, that it was ready to get tough on the bankers who caused the 2008 financial crisis. On March 16 the Federal Deposit Insurance Corporation, or FDIC, sued three former top executives of Washington Mutual, or WaMu, for taking “extreme and historically unprecedented risks,” thereby causing the bank to lose “billions of dollars.” That same day, the New York Times reported that the Securities and Exchange Commission had sent so-called Wells notices—often a sign that civil charges are imminent—to a handful of former executives at mortgage-securitization giants Fannie Mae and Freddie Mac.

The targets seem well-chosen. The collapse of WaMu, acquired by JPMorgan Chase at a fire-sale price in the fall of 2008 was, according to the FDIC, the biggest bank failure in U.S. history. The FDIC is seeking to recover $900 million from the three bankers. Fannie and Freddie were taken over by the government in the fall of 2008. So far, they have cost taxpayers about $130 billion.

Perhaps you’re thinking: If only the government had known at the time what these scoundrels were up to, we could all have been spared a great deal of pain. The trouble with that line of reasoning is that, um, the government did know what was going on. The Office of Thrift Supervision, which regulated WaMu, and the Office of Housing Enterprise Oversight, which regulated Fannie and Freddie, were supervising the very behavior that their sister agencies are now suing over. The government’s lawsuits call to mind a cynical boast by Burt Lancaster, playing tabloid power broker J.J. Hunsecker, in the 1957 noir classic Sweet Smell of Success:  “My right hand hasn’t seen my left hand in 30 years.”

The FDIC’s complaint against WaMu alleges that the three executives—former CEO Kerry Killinger, former Chief Operating Officer Stephen Rotella, and former President of Home Lending David Schneider—”focused on short term gains to increase their own compensation, with reckless disregard for WaMu’s longer term safety and soundness.”  Or as Killinger put it in a June 2004 memo, “”Above average creation of shareholder value requires significant risk taking.” The FDIC complaint basically says that as experienced bankers, the three should have known better. Yet they repeatedly ignored warnings from risk managers, including one who said that WaMu was “putting borrowers into homes that they simply cannot afford.”  According to the complaint, the three not only embraced risky loans, but “layered these already risky products with additional risk factors.” Both Killinger and Rotella were “heard to deride risk managers as ‘checkers, checkers, checkers.’ ” Both Killinger and Rotella have come out swinging in their own defense, insisting that they took what steps they could to save WaMu.  (Schneider has been silent.)

The FDIC has marshaled an impressive amount of evidence against Killinger, Rotella, and Schneider, but its complaint doesn’t have much to say about WaMu’s chief regulator, the Office of Thrift Supervision.  Not quite one year ago, when the Senate Permanent Subcommittee on Investigations looked into OTS’s role in the 2008 meltdown, committee chairman Sen. Carl Levin, D.-Mich, observed, “[M]ost of those financial firms couldn’t have done what they did unless their regulators let them.” These regulators, Levin said, “saw the shoddy lending practices, saw the high risk lending, saw the substandard securitizations, understood the risk, but let the banks do it anyway.” OTS’s oversight of WaMu was Levin’s chief example.

One reason the OTS didn’t act, according to Levin, was that OTS was almost as fixated on short-term profits as WaMu was. These “precluded enforcement action to stop the bank’s use of shoddy lending,” the Senate committee concluded. One OTS employee wrote to another in September 2005:”It has been hard for us to justify doing much more than constantly nagging (okay, ‘chastising’) … since they [WaMu] have not been really adversely impacted in terms of losses.” While WaMu executives layered risk upon risk in subprime loans, the regulators did nothing to stop them. Rather than issue regulations to prohibit banks’ risky mortgage practices, the regulators issued a tepid “guidance” instead—and that “Interagency Guidance on Nontraditional Mortgage Products” wasn’t  issued until the fall of 2006, by which time the horse was already pretty much out of the barn.  While WaMu’s executives allegedly ignored their own risk managers telling them that borrowers couldn’t pay back their loans, federal banking regulators ignored consumer advocates telling them exactly the same thing!

As the FDIC started to worry about WaMu’s financial health—WaMu’s deposits were insured by the FDIC—the OTS, Levin said, “acted like a WaMu guard dog, trying to keep the FDIC at bay.”  It wasn’t until September 2008 that the OTS took its first formal enforcement action against WaMu; the FDIC had been trying to persuade the OTS to get moving for more than a month. The FDIC, Rotella complained in his press statement, isn’t blameless either; it “actively participated in the examination of WaMu, rating the bank Satisfactory or better until the middle of 2008, just months before it seized the bank.” This calls to mind another pearl of cinematic cynicism, from 1978’s Animal House: “You fucked up! You trusted us!” (Granted, the FDIC was not WaMu’s primary regulator.)

While the evidence of the government’s complicity is infuriating, it may not hurt the FDIC’s case, legally speaking. Indeed, a legal source says that at trial, the FDIC will argue that the OTS’s actions (or rather, lack of actions) are irrelevant, and shouldn’t be admitted as evidence, because the OTS had no legal obligation to force WaMu’s executives to do anything. Of course, the defense lawyers will try mightily to get the jury to hear all about OTS’s cluelessness.

In the meantime, the SEC, which is reportedly contemplating charges against former Fannie and Freddie executives, has its own left-hand/right-hand paradox. The SEC is said to be weighing whether to charge Fannie executives with classifying mortgage loans as “prime,” or relatively safe, when they should have been put in a category that reflected more risk. The SEC is similarly pondering whether to charge Freddie executives with not fully warning investors about the risks associated with its subprime mortgage portfolio. But as the Wall Street Journal noted, such accusations put another government regulator in the line of fire. That agency was formerly known as the Office of Federal Housing Enterprise Oversight, or OFHEO; it has lately been renamed the Federal Housing Finance Agency. The Journal reported that this successor agency to OFHEO sent a letter to the SEC opposing the charges.

As the Journal pointed out, OFHEO’s blessing of Fannie’s financial filings was one reason a federal judge threw out some charges in a shareholder lawsuit against Fannie executives. Fannie, the judge said, “operated in a heavily regulated environment.” Since the government takeover, the judge added, “no restatements of Fannie’s financials have been ordered.” Perhaps you could argue that the Fannie and Freddie executives misled OFHEO—but that is not an argument OFHEO has made, at least not publicly,  possibly because reporters were already writing about Fannie and Freddie’s problems well before their collapse.

Sources tell me that there was a general complicity on the part of federal regulators—not just OFHEO, but Treasury too—as the financial crisis got into full swing. The hope was that if regulators didn’t force Fannie and Freddie to own up to just how bad the losses might be—they call this “regulatory forbearance”—then Fannie and Freddie would outrun their bad loans. Regulators were also reluctant to take a hard line because they knew it might force a government takeover, for which there was no political appetite.

Such left-hand/right-hand problems don’t arise when the litigant resides in the private sector.  Earlier this month, the National Credit Union Association threatened to sue several investment banks unless they refunded more than $50 billion in mortgage-backed securities sold to five credit unions that subsequently collapsed. I have not been able to understand why federal regulators have been so reluctant to hold Wall Street accountable for its role in packaging up bad mortgages.  Could it be that failed firms make easier targets than the too-big-to-fail banks that now dominate our financial landscape?