WaMu's Failure Reveals Regulator Bumbling

A new Treasury investigation will conclude that the FDIC and Office of Thrift Supervision (OTS) are both to blame for failing to properly supervise Washington Mutual (WaMu) prior to its spectacular failure, according the New York Times. The newspaper managed to secure a draft the report early, so the document's precise findings remain unclear at this time. But according to the Times, the regulators often clashed over the bank before its major inadequacies became apparent.

Overall, OTS did a poor job evaluating the bank. The NY Times reports:

Although regulators found problems with the quality of the mortgages it had originated and with the wholesale loans it bought through outside brokers and banks, the office consistently deemed WaMu "fundamentally sound," giving it a rating of 2, the second-highest on a five-point scale used to assess a bank's condition, from 2001-7. Moreover, the office relied on WaMu's own tracking system to follow up on regulators' findings.

The office did not lower the rating to 3 ("exhibits some degree of supervisory concern") until February 2008, and to 4 ("unsafe and unsound") until September 2008, days before WaMu collapsed. "It is difficult to understand how O.T.S. continued to assign WaMu a composite 2 rating year after year," the report found.

The FDIC recognized some of the problems the OTS overlooked, but failed to act:

But the report also leveled unexpectedly sharp criticism at the F.D.I.C., which by July 2008 concluded that the bank needed $5 billion in capital to withstand future potential losses. The report said the F.D.I.C., which had questioned the Office of Thrift Supervision's assessments of the bank's soundness, could have stepped in earlier and acted as the primary regulator, but decided "it was easier to use moral suasion to attempt to convince the O.T.S. to change its rating."

So much for the benefits of regulator coordination? That pressure on the part of the FDIC obviously failed to do the trick quickly enough. When the bank eventually did run into trouble, the OTS wanted to rehabilitate it, while the FDIC wanted a more aggressive effort to reduce the cost of WaMu's potential failure.

Ultimately, the report concludes that the FDIC should make its own risk assessments of systemically risky banks going forward, says the Times. That seems sensible, given this lesson courtesy of Wamu.

But this incident also could have some broader consequences for the financial reform push in Congress right now. The legislation seeks to eliminate some bank regulator overlap. This incident indicates that is probably a good idea. Moreover, both the House and Senate versions of regulation would abolish the OTS. The WaMu debacle would support this move as well.

Yet would the FDIC have acted if it was the bank's sole regulator? Then it wouldn't have needed to pressure OTS to revise its ratings. Maybe, maybe not. If the FDIC was so certain that WaMu's situation demanded more aggressive action, then it's hard to imagine why it would have sat back and waited for OTS to get its act together. Instead, it probably just did not want to appear to be too aggressive of a regulator. That problem could persist even if overlap is eliminated. A lesson from the crisis is not only that regulators need to pay more attention, but that they must enforce the consequences of their findings. Observation isn't enough to avoid another crisis if paired with inaction.