Wall Street and the Financial Crisis: Anatomy of a Financial Collapse


E. Preventing Regulatory Failures

Regulators stood on the sidelines as U.S. mortgage lenders introduced increasingly high risk mortgage products into the U.S. mortgage market. Stated income loans, NINA loans, and so-called "liar loans" were issued without verifying the borrower's income or assets. Alt A loans also had reduced documentation requirements. Interest-only loans, Option ARMs, and hybrid ARMs involved charging low introductory interest rates on loans that could be refinanced before much higher interest rates took effect. Negative amortization loans – loans that became bigger rather than smaller over time – became commonplace. Home equity loans and lines of credit, piggybacks and silent seconds, 100% financing – all involved loans that required the borrower to make virtually no down payment or equity investment in the property, relying instead on the value of the property to ensure repayment of the loan. All of these loans involved higher risks than the 30-year and 15-year fixed rate mortgages that dominated the U.S. mortgage market prior to 2004. When property values stopped climbing in late 2006, these higher risk loans began incurring delinquencies, losses, and defaults at record rates.

A number of new developments have occurred in the past several years to address the problems highlighted throughout this Report.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which the President signed into law on July 21, 2010, contains many changes in the law that will be implemented over the next year. The Dodd-Frank changes include abolishing OTS, banning stated income loans, and restricting negative amortization loans. Other developments include a revised interagency agreement strengthening the FDIC's ability to conduct examinations of insured depository institutions and a new FDIC deposit insurance pricing system that requires higher risk institutions to pay higher insurance fees.

OTS Abolished. One significant new change brought about by the Dodd-Frank Act is the abolishment of the Office of Thrift Supervision. Title III of the Dodd-Frank Act reassigned OTS' duties and personnel to other agencies, primarily the Office of the Comptroller of the Currency (OCC). |945| Although some OTS officials claim the law intended OTS to be a merger partner with the OCC, the statute is clear in its intent to abolish OTS, rather than effect a merger of equals.

Revised Interagency Agreement. A second important change is that the interagency agreement that guides when the FDIC can examine an insured institution was altered to give the FDIC increased authority. Under federal law, the FDIC can conduct an examination of an insured depository institution "whenever the [FDIC] Board of Directors determines a special examination … is necessary to determine the condition of such depository institution for insurance purposes." |946| Despite this broad statutory grant of examination authority, in 2002, the FDIC agreed to limit the circumstances in which it would examine banks subject to regulation by another agency. The resulting interagency agreement essentially required the FDIC to establish that an institution was at "heightened risk" of causing loss to the Deposit Insurance Fund before the FDIC could compel another banking regulator to allow the FDIC to participate in an examination of its operations. OTS used that agreement to impede the FDIC's participation in examinations of WaMu.

In 2010, the FDIC renegotiated that agreement with the other financial regulators, and they signed a revised version that will facilitate more cooperation on a less bureaucratic and more timely basis. |947| Compared to the 2002 version, the revised agreement explicitly provides for special examinations of a broader scope of insured depository institutions. It also streamlined the process for resolving differences in CAMELS ratings between financial regulators. In the case of WaMu, this new process would have helped facilitate a quicker response to WaMu's deteriorating condition. Additionally, the new agreement establishes a continuous on-site FDIC presence, with five or more examiners, at certain large institutions, including those that receive ratings under the FDIC's Large Insured Depository Institutions Program. This new provision ensures the FDIC has consistent access to information about big banks that, by virtue of their size, pose the most risk to the Deposit Insurance Fund. Finally, after first discussing it with the primary federal regulator, the FDIC is permitted to gather information directly from financial institutions. These provisions will help ensure that the FDIC can obtain the information needed to safeguard the Deposit Insurance Fund.

Risk Factors in Insurance Fees. Under a new FDIC deposit insurance pricing system that takes effect in 2011, large depository institutions with higher risk activities will be required to pay higher fees into the Deposit Insurance Fund. |948| This new assessment system is designed to "better capture risk at the time large institutions assume the risk, to better differentiate among institutions for risk and take a more forward-looking view of risk, [and] to better take into account the losses that the FDIC may incur if such an insured depository institution fails." |949| It is the product of both past FDIC revisions and changes to the insurance fund assessment system made by the Dodd-Frank Act. |950| It is intended to impose higher assessments on large banks "with high-risk asset concentrations, less stable balance sheet liquidity, or potentially higher loss severity in the event of failure," and impose those higher assessments when the banks "assume these risks rather than when conditions deteriorate." |951| Under this new system, banks with higher risk activities will be assessed higher fees, not only to safeguard the insurance fund and allocate insurance costs more fairly, but also to help discourage high risk activities.

Financial Stability Oversight Council. The Dodd-Frank Act has also established a new intra-governmental council, the Financial Stability Oversight Council (FSOC), to identify systemic risks and respond to emerging threats to the stability of the U.S. financial system. |952| The council is comprised of ten existing regulators in the financial services sector, including the Chairman of the Federal Reserve Board of Governors, the Chairman of the FDIC, and the Comptroller of the Currency, and is chaired by the Secretary of the Treasury. This Council is intended to ensure that U.S. financial regulators consider the safety and soundness of not only individual financial institutions, but also of U.S. financial markets and systems as a whole.

To further strengthen oversight of financial institutions to reduce risk, protect U.S. financial markets and the economy, and safeguard the Deposit Insurance Fund, this Report makes the following recommendations.

    1. Complete OTS Dismantling. The Office of the Comptroller of the Currency (OCC) should complete the dismantling of the Office of Thrift Supervision (OTS), despite attempts by some OTS officials to preserve the agency's identity and influence within the OCC.

    2. Strengthen Enforcement. Federal banking regulators should conduct a review of their major financial institutions to identify those with ongoing, serious deficiencies, and review their enforcement approach to those institutions to eliminate any policy of deference to bank management, inflated CAMELS ratings, or use of short term profits to excuse high risk activities.

    3. Strengthen CAMELS Ratings. Federal banking regulators should undertake a comprehensive review of the CAMELS ratings system to produce ratings that signal whether an institution is expected operate in a safe and sound manner over a specified period of time, asset quality ratings that reflect embedded risks rather than short term profits, management ratings that reflect any ongoing failure to correct identified deficiencies, and composite ratings that discourage systemic risks.

    4. Evaluate Impacts of High Risk Lending. The Financial Stability Oversight Council should undertake a study to identify high risk lending practices at financial institutions, and evaluate the nature and significance of the impacts that these practices may have on U.S. financial systems as a whole.


945. See, e.g., Section 312 of the Dodd- Frank Act. [Back]

946. 12 U.S.C. § 1820(b)(3). [Back]

947. 9/17/2010 letter from FDIC Chairman Sheila C. Bair to the Subcommittee, PSI- FDIC- 13- 000001 ( "Enclosed please find a signed copy of a revised and much- strengthened memorandum of understanding among the FDIC and other bank regulators which will greatly enhance our ability to continually access and monitor information related to our risks as deposit insurer. I believe this is a very strong agreement and one which we accomplished due in no small part to the work of your Subcommittee in identifying weaknesses in the supervisory processes leading up to the failure of Washington Mutual." ). [Back]

948. See 2/7/2011 FDIC Final Rule of Assessments, Dividends, Assessment Base and Large Bank Pricing, RIN 3064. [Back]

949. Id. [Back]

950. See Sections 331, 332 and 334 of the Dodd-Frank Act. [Back]

951. 2/7/2011 FDIC press release, "FDIC Approves Final Rule of Assessments, Dividends, Assessment Base and Large Bank Pricing," http://www.fdic.gov/news/news/press/2011/pr11028.html. [Back]

952. See Title I, Subtitle A, of the Dodd- Frank Act establishing the Financial Stability Oversight Council, including Section 112(a) which provides its purposes and duties. [Back]

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