Regulating AIG: Who Fell Asleep On The Job?

The standard line on what went wrong at AIG, the insurance giant whose collapse triggered a $170 billion federal bailout, was that the company fell into some sort of regulatory gap.

From members of Congress to Federal Reserve Chairman Ben Bernanke, the story was clear: Hundreds of regulators around the globe missed the calamity in the making because none of them was watching over the whole country.

But the narrative took a turn on March 5, just as a Federal Reserve officer was telling a congressional hearing that the problem had been a lack of any single figure in charge. The narrative turned because a single figure spoke up.

Scott Polakoff, interim director of the Office of Thrift Supervision, sat hunched over. He looked over his glasses and addressed the committee chair. "Senator, may I make a comment?" he began. "It's time for the OTS to raise their hand and say they have some responsibility and accountability here. We were deemed an acceptable regulator for both U.S. and domestic and international operations."

It wasn't a huge apology, but Polakoff was clearly saying, "Blame us."

The OTS regulates thrifts, and holding companies like AIG that own thrifts, which is another name for savings and loans. The lawmakers were surprised.

"I was struck by your acknowledgment that you were the regulator that we've been looking for," said Sen. Mel Martinez (R-FL). "I think we had assumed there wasn't one."

"Yes, sir," Polakoff told him. "I'm the one."

A Quiet Agency

It's a safe bet that many people have never heard of the Office of Thrift Supervision.

Patricia McCoy, a law professor at the University of Connecticut, studies failed banks. Late one night, she was making a chart of major bank failures in 2007 and 2008 and noticed that in the category of regulators, she was typing in "OTS" repeatedly.

"I went, 'What happened at this agency?' " she says. "It's been flying under the radar and we didn't notice."

On her list were names like IndyMac, the most expensive bank failure of this economic crisis. The second most expensive is BankUnited, also regulated by the OTS. The largest bank ever to fail was Washington Mutual, another OTS concern. The list of OTS failures extends to giants like Countrywide and AIG.

The OTS declined a request for an interview about AIG.

William Black, who used to work at the OTS in the early 1990s, says there's no way the agency could ever stand up to the likes of AIG. It would be like sending a scrawny, gangly 13-year-old against a super heavyweight. "That was the OTS," says Black, now a professor at the University of Missouri in Kansas City.

Shopping For Regulators

Two crazy facts about the American system of regulating banks make clear why the parties are so mismatched. The first is that national banks choose their regulators — they go shopping. The second is that regulators want to get picked, because banks pay them for the service of regulation.

With respect to both those facts, the Office of Thrift Supervision was born at exactly the wrong time. It was 1989, and the savings and loan crisis was in full swing. Thrifts were dropping dead by the hundreds. The OTS was the thrift regulator — it needed thrifts to pay for its budget. As the thrifts continued to fail and revenue declined, OTS staff members worried they'd lose their jobs.

The OTS couldn't hold a news conference and announce a "going out of business" sale. It couldn't start pitching itself as the most lax regulator in town. But the staff members did head out to industry meetings, where they talked up the agency's services.

And they did show up at key news conferences, just to make their presence known.

McCoy and Black tell the story of federal regulators getting together in June 2003 to announce their campaign for easing regulation. James Gilleran, who was then the head of the OTS, was ready.

"They're all grinning broadly and poised over a stack of federal regulations to demonstrate their intention to cut through the federal regulations," Black says.

"The other federal regulators showed up with garden shears," McCoy says. "Gilleran showed up with a chainsaw."

Companies got the message. You needed a thrift to be regulated by the OTS. General Motors got one, and shortly after, so did GE, H&R Block and a large insurance conglomerate called AIG.

OTS Just A Sideshow?

Veteran regulation lawyer Mike Roster says there are far bigger culprits in the economic crisis than the OTS. He insists that any regulatory agency responsible for AIG would have produced the same result.

"I don't care who was [AIG's] regulator," he insists. "I don't think they would have caught this."

Roster says it makes more sense to blame Congress, which in 2000 passed the Commodity Futures Modernization Act, a measure that made it nearly impossible to regulate the derivatives that got AIG in so much trouble. Be angry at them, he says.

Or how about rating agencies, which gave AIG endless stamps of approval? Be angry at them, Roster says.

The OTS, he argues, is just a footnote. "I hope we don't get diverted to that sideshow," he says. "It's getting diverted to sideshows that, unfortunately, doesn't solve things."

Last fall, then-Treasury Secretary Henry Paulson recommended getting rid of the OTS. As part of his push for a regulatory overhaul this year, President Obama is likely to recommend the same thing in the next couple of weeks.

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