OTS 'Fell Short' Regulating AIG Credit Swaps, Polakoff Says

By Hugh Son and Margaret Chadbourn
Bloomberg News
March 5, 2009

March 5 (Bloomberg) -- The Office of Thrift Supervision "fell short" in its oversight of American International Group Inc., the insurer that needed four government rescues, the agency's acting director told a Senate panel today.

The regulator "did not sufficiently assess the susceptibility of highly illiquid, complex instruments," to ratings downgrades, Scott Polakoff told the banking committee in prepared testimony today. "In hindsight, OTS should have directed the company to stop originating credit-default swap products before December 2005."

The OTS is under pressure to improve oversight after the Treasury said the regulator failed to adequately supervise IndyMac Bancorp before the lender's collapse. Lawmakers are frustrated that risky bets at AIG, also supervised by the OTS, jeopardized the stability of the banking system and required a bailout that was expanded this week.

Polakoff endorsed a so-called systemic risk regulator to help supervise companies such as AIG, which posted a record $61.7 billion fourth-quarter loss on March 2. The New York-based company's insurance operations are supervised by state regulators while the OTS oversees its lending unit and the operations that sold credit-default swaps.

The government agreed March 2 to inject as much as $30 billion in additional capital into AIG after Chief Executive Officer Edward Liddy was unable to sell enough units to repay the loan portion of a bailout package previously valued at $150 billion.

'Adverse Effects'

Federal Reserve Chairman Ben S. Bernanke told the Senate Budget Committee this week that because AIG has so many counterparties, its failure "would have had very adverse effects on the banking system." The company's growth in risky markets is attributable to a lack of regulation, he said.

Banks relied on AIG's financial products unit to back about $298 billion of assets through derivative contracts at year-end.

OTS showed "supervisory weakness" and "did not take forceful action" to curtail losses from subprime, option adjustable-rate and other nontraditional loans, the Treasury said in a report last week on the causes of IndyMac's failure.

"We believe that OTS should have done much more to ensure IndyMac tightened its loan underwriting early on when the thrift was establishing its business strategy," said the report, issued by the Office of the Inspector General at the Treasury. "It is essential that OTS senior leadership reflect carefully on the supervision that was exercised over IndyMac and ensure that the correct lessons are taken away from this failure."

The agency is expanding regulatory efforts by creating a division to monitor the 25 largest thrifts and setting up new standards for reviewing and approving enforcement actions, OTS director John Reich said last month before stepping down.

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