06/21/2010 05:12 am ET Updated May 25, 2011

The Office of Thrift Supervision: A Case Study in Republican Regulatory Neglect

There probably couldn't be a worse time than now for Americans to have lost faith in their government. And yet, that is the case. The most recent survey issued by the Pew Research Center a few days ago tells us that a scant 22% of Americans trust the federal government most of the time. Half the people in the country believe that when government runs something, it is usually inefficient and wasteful. Further, 58% of Americans say the government has gone too far in regulating business.

Two reasons seem to stand out as explanations: from 2000-2008, the Bush Administration showed us it had little interest and, frankly, limited capacity to actually govern. Bush and company failed in ways that have undermined Americans' confidence in the ability of government to solve the country's most pressing problems. Second, the massive bailout of Wall Street didn't help improve the image of the federal government in the eyes of its citizens. In fact, it had quite the opposite effect.

These combined factors have made the job of leading the country more difficult for President Obama. But do most Americans really want to drown government in a bathtub, as Grover Norquist famously said? The good news from the Pew Center is that most Americans (61%) do support stricter regulation of the financial services industry. Still, whatever financial overhaul bill emerges from Congress won't matter much if the rules aren't enforced. A little history with a focus on a little-known agency is in order.

Financial regulators during the Bush era kept their foot off the pedal for ideological reasons. At the Securities and Exchange Commission, for example, Republican Christopher Cox and his colleagues failed to spot Bernie Madoff's Ponzi scheme and totally missed the accounting shenanigans at Lehman Brothers.

Another agency on few people's radar screen is the Office of Thrift Supervision (OTS). The mission of the OTS is to regulate federal thrifts.

Exhibit 1. Indy Mac. On February 26, 2009, the Treasury Department's Inspector General issued a report critical of the OTS under former director John Reich. report said that regulators ignored repeated warning signs and should have seen that Indy Mac was "built" - I use that term loosely - on shaky loans based on inflated property values. The inspector general said the OTS should have taken enforcement action against Indy Mac more than two years before the bank was finally seized by the FDIC on July 11, 2008. The bank was finally undone by its lax loan standards that allowed people to borrow money without documenting their income. The report concluded that OTS laxity added significantly to the FDIC's substantial losses from the bank's failure.

Exhibit 2. Washington Mutual. The failure of WaMu, as it was known, was almost a carbon copy of the Indy Mac collapse, except for its scale. This was the largest bank failure in U.S. history. Senate investigators placed the primary blame on WaMu executives whose search for profits led to the bank's failure and sale to JPMorgan Chase in 2008. Former CEO Kerry Killinger steered the bank into adjustable-rate subprime mortgages, only to discover too late that the thrift was lending to many unqualified borrowers. Senate investigators also found fault with Washington Mutual's compensation system, which gave bonuses to loan officers who made subprime loans even if the borrower qualified for a conventional loan.

But Senator Carl Levin also unloaded on Mr. Reich at his subcommittee's hearing into the matter on April 16th. the senior Senator from Michigan: "Washington Mutual's collapse is a tale of greed and mismanagement, but it is also a case history of ineffective bank regulators who saw years of unsafe and unsound banking practices, but failed to stop them. OTS was more of a spectator on the sidelines, a watchdog with no bite, not acting to correct the flaws and failures it saw." Senate staffers also called out Mr. Reich by name for...

• impeding efforts by the FDIC to independently examine the bank as its condition worsened;
• having too cozy a relationship with WaMu executives; and
• being unable to account for a six-month delay in issuing an enforcement order to WaMu in 2008

It should be noted that Mr. Reich was appointed by Mr. Bush as director of OTS in 2005; he resigned in February of last year.

The Obama Administration has proposed eliminating the OTS and merging its duties into the Office of the Comptroller of the Currency (OCC). The OCC's chief function is to charter, regulate and supervise national banks. At first glance, this might seem like good news. But the current comptroller is another Bush appointee, John Dugan, who has consistently opposed efforts by state officials who try to crack down on abusive consumer lending practices. He maintains that national banks aren't subject to stronger state laws. Mr. Dugan has also made plain his disdain for financial reforms currently being advocated by other regulators. Thankfully, his term expires this August.

The main lesson we can glean from the recent history of the Office of Thrift Supervision is that regulations don't mean anything if the regulator has no interest in regulating. Alan Greenspan's tenure at the Federal Reserve is the most-often cited example of this fact. A corollary of this lesson is that, in general, Democratic administrations are more likely to believe in oversight than Republican administrations.

(Can anyone forget Michael "You're doing a heck of a job" Brown, the beleaguered director of FEMA when Hurricane Katrina struck the Gulf Coast?)

So whatever bill emerges from Congress in the area of Wall Street regulation, much will depend on who is left to enforce the new rules. New financial laws are absolutely necessary, but the cop on the beat has to believe in his or her job if they are to be successfully implemented and enforced. The history of recent Republican administrations should give us cause for concern that future Wall Street bubbles and busts are unavoidable.

A major challenge for the Obama administration is to help restore the credibility of the federal government so that it can deliver solutions for the country's most pressing problems. Should the president succeed, what appears to be unavoidable doesn't have to be.