Multistate Predatory Lending Negotiations Exercise

The Bismark Bank (“Bismark”) is a state chartered bank headquartered in the State of North Dakota. It is now the nation’s largest bank, having been formed through a series of acquisitions consummated by its current president, George Bailey. It is one of the largest employers in North Dakota, with its corporate offices as well as its mortgage financing, credit card, and telemarketing centers all located in North Dakota.

Through Bailey’s leadership, Bismark also has acquired other financial institutions. As the real estate boom began to accelerate in 2004, Bailey acquired his “crown jewel,” Old Pacific Mortgage (“OPM”), a mortgage lending institution. OPM is the largest mortgage lending institution in the nation, and is based in California.

Old Pacific Mortgage grew rapidly as a result of the efforts of its leader, Miranda Priestly. Priestly is a scrappy businesswoman, who built OPM from a small, storefront lender centered in Queens and the Bronx to the nation’s leading lender to the underserved lower middle and poorer classes. Priestly’s parents ran a small supermarket in Queens, and could not afford their own home. Priestly believes home ownership should be the dream of every American, and she vowed to ensure that OPM would service worthy borrowers that other lenders would not touch. In the beginning she ensured that everyone she hired similarly believed in the “mission” of OPM.

As OPM grew larger, Priestly was no longer able to engage in day to day management of the company. One of the last management roles she had to give up was direct involvement in the hiring process of OPM employees. Instead, she resorted to instructing her top lieutenants to stay true to the mission, but to make sure the company was extremely profitable as well, so that it could continue to accomplish its goals — servicing borrowers in the lower middle and poorer communities in all 50 states. She also told her top lieutenants to ensure that all of their subordinates understood and carried out the mission.

Towards the end of 2006, two years after Bismark’s acquisition of OPM, the North Dakota Commissioner of Banking, Pat Geary, noticed an uptick in complaints against OPM. More and more customers were falling behind on their mortgages and going into foreclosure. After investigating the matter, Geary discovered that OPM was engaged in a number of practices that violated North Dakota’s banking law, including falsifying income statements on lending documents so that the consumers qualified for mortgages that they could not afford and requiring borrowers to pay penalties if they paid down their mortgages sooner than originally anticipated (“prepayment penalties”). For the period 2004–2008, there were 5,000 loans in North Dakota that involved falsified income states.

Geary’s staff also discovered that the falsified income statements were endemic to OPM’s nationwide practice. At a January 2008 conference with other state banking officials, Geary set up a special meeting with her counterparts in California, Illinois, and New Hampshire to discuss OPM’s practices. They informed the other banking regulators that in California there were 50,000 affected loans, in Illinois there were 40,000 affected loans, and in New Hampshire there were 5,000, all from 2004–2008. Nationwide, there were hundreds of thousands of such loans.

Geary also met with the Chief of the North Dakota Attorney General’s Consumer Protection division, Hamilton Burger, in January 2008 to discuss the problems with OPM. After reviewing the data, loan documents and borrower statements collected by the North Dakota Banking Department, Burger determined that there appeared to be numerous violations of North Dakota’s five–year–old predatory lending law, including failing to ensure loans were suitable for borrowers and requiring borrowers to pay prepayment penalties. Burger also thought these practices violated the state’s 50–year–old unfair and deceptive practices (“UDAP”) law.

In May 2008, Burger sent a packet of information about OPM’s practices to the chiefs of the consumer protection divisions of the Attorney General office of California (Paul Biegler), Illinois (Jack Ross), and New Hampshire (Julie March). After a series of emails and conference calls with 3 other states, a multistate task force was formed. The Executive Committee consisted of North Dakota, Illinois, and New Hampshire. California was not part of the Executive Committee, but was included in the discussions because it had initiated its own separate investigation.

The four AG consumer protection chiefs then held a series of conference calls over the summer and fall of 2008 to determine whether the activities of OPM violated laws in all four states, and whether to act collectively or on their own. The chiefs noted that of the four states, none, other than North Dakota, had a “suitability” requirement in its lending law. But all four chiefs believed that there was a strong argument that OPM’s activities were “unfair” under each state’s UDAP law, and thus likely violated the UDAP laws of most states.

On November 1, 2008, Burger called OPM’s general counsel, Marty Bach, to discuss the states’ concerns with OPM’s practices. Realizing that the allegations were serious, Bach then contacted Priestly and Bailey, and, at Priestly’s suggestion, the three decided to call OPM’s best outside litigator, Vincent Gambini, to represent OPM and Bismark in this matter. Gambini was no stranger to OPM’s legal troubles, having represented OPM in a prior SEC action (in which he defeated them in a preliminary injunction hearing) and in two nasty shareholder lawsuits. Gambini has a reputation of taking tough positions in negotiations and being willing to actually try cases if he doesn’t get his way. Meanwhile, a search on Westlaw reveals that other than Jack Ross, of Illinois, none of the states’ attorneys on the Executive Committee, has ever tried a multimillion dollar consumer case.

Gambini and Bach met four times with Burger, Biegler, Ross, and March, from January 2009 through August 2010, to discuss the states’ concerns. At the fourth meeting, in August 2010, Gambini and Bach told the states that they were willing to reform some practices, but that they believed that most states’ lending laws didn’t implicate any of OPM’s activities. They also indicated they were willing to pay about $10 million total to the states for restitution and investigative costs and attorneys’ fees (but no penalties), to distribute as they saw fit, and to sign a weak consent judgment that did not include a reference to 4 any lending laws, but that any consent decree had to “buy them peace,” i.e., settle with all the states. The states in turn had demanded that Bismark and OPM sign a consent decree that contained the following provisions:

1. A fund of $50 million to provide consumers in all 50 states with restitution for the loans that are in default,
2. $10 million in penalties,
3. $5 million in investigative costs and attorneys’ fees,
4. Injunctive relief that prohibits the companies from violating states’ lending laws, and
5. Priestly be named as a defendant and personally bound by the injunctive provisions of the settlement.

The states decided to set up one last meeting between the parties. All principals were asked to attend. This meeting is scheduled for November 11, 2010.

Prior to the last meeting, Mississippi announced that it had just hired famed plaintiffs’ class action attorney Frank Galvin from Chicago to represent the state on a contingency fee basis in this matter. None of the states’ lawyers knew Galvin personally, although they all had read the stories about his private jet and the millions he had made in the tobacco litigation, and they loathed what he represented. Galvin held a news conference surrounded by people who had lost their homes and a dozen bankers’ boxes of what he claimed were leaked internal memoranda showing that OPM knew it was driving people out of their homes and promising to file suit “in a few days.” Both the bankers and states thought this was just a publicity stunt. In any event, Mississippi’s Attorney General, Alicia Florrick, who just became President of the National Association of Attorneys’ General, insisted that Galvin be permitted to participate in the final negotiating session, and the bankers and the states reluctantly agreed.

On June 15, 2010, California and nine other states (none of which are on the Executive Committee in this matter) announced that they had reached a settlement of predatory lending practices against American Dream Mortgage Company (“American Dream”). The American Dream settlement resulted in a $40 million restitution fund, and $15 million in penalties and attorneys’ fees paid to 10 states. There was no mention of predatory lending law violations in the American Dream settlement — American Dream only agreed in general terms not to engage in unfair and deceptive practices in the future — and no company executive was named in the settlement. Suffice it to say, there is plenty of room to disagree about whether the activities of American Dream were better or worse than the alleged activities of OPM.

Before the final negotiating session, Bismark CEO Bailey called the North Dakota Attorney General, Rusty Sabich, to discuss North Dakota’s concerns about OPM’s lending activities. Bailey assured Sabich that he thought a reasonable settlement could be worked out. He also alerted Sabich to the news that would come out the following day: Bismark is considering flipping its charter, so that it would no longer be a state–chartered bank and instead would become a federal bank. The Bismark Free Press subsequently reported that if that happened, the North Dakota Bureau of Banking would lose fees from its largest state bank, which would cut the Bureau’s budget by 10%.

At the end of the last quarter, Bismark announced that it had a $1.2 billion loss for the quarter. Analysts blamed the loss on poor earnings resulting from delinquent loans to OPM customers. An article in the Wall Street Journal quoted unnamed analysts as suggesting that Bismark would be better off if it divested OPM, especially since there were rumors that Congress might hold hearings and subpoena Bismark and OPM officials to discuss predatory lending and its effects on poor, minority customers.

Following the Citizens United decision, Priestly announced that OPM would be making independent election contributions to support candidates who “believe in free enterprise and pursuit of the American Dream.” Its first contribution was $100,000 in independent contributions to support Jay Bulworth in his special election for U.S. Senate in which he defeated the Florida Attorney General, Claude Dancer. The Miami Herald reported that Dancer’s office had previously brought an enforcement action against OPM that had resulted in a $50,000 penalty. Priestly angrily denied that there was any connection between the enforcement action and the campaign contribution. This year, the California Attorney General, Daniel Kafee, is running for Governor, and the Mississippi Attorney General, Alicia Florrick, is running for re–election (and is currently behind in the polls), but the Attorneys General in the other states on the Executive Committee are not up for re–election.

Just prior to the negotiating session, New Hampshire’s Democratic Governor, Jack Slater, nominated the Chief of the New Hampshire Consumer Protection Division, Julie March, to a seat on the state Public Utilities Commission. Since the Executive Council in New Hampshire that considers such nominations is controlled by Republicans, one of whom who told the Manchester Union Leader that “this nomination should evaluated very carefully since I have heard that this Assistant Attorney General is anti–business,” it is not immediately clear when this nomination will be voted upon or approved.

The issues to be decided at the November 11 negotiations are:

1. The maximum size of the restitution fund, and whether the states’ consumers could access it for refunds.
2. Whether there will be penalties paid to the states, and if so, the amount of the penalties.
3. Whether there will be investigative fees and attorneys’ fees paid to the states, and if so, how much.
4. Whether the consent decree will prohibit activities that violate the lending laws of (a) all 50 states; (b) North Dakota only; or© none of the states, i.e., no specific reference to this issue at all.
5. Whether Priestly will be a named defendant and be bound by any injunction.

Parties to the negotiations on November 11 will be the consumer heads from North Dakota, California, Illinois, and New Hampshire for the states, Galvin on behalf of Mississippi, and the heads of Bismark and OPM, and their inside and outside counsel. Each individual negotiator will be given additional, private, instructions. The individual can keep these additional instructions secret, or disclose them if he or she thinks it would help the negotiations.

Each state team (including Galvin) and each company team can (and should) meet separately before the negotiations on November 11 to plan strategy, but the two opposing sides may not meet prior to November 11. Also, each team should not meet with their counterparts from the other team, i.e., the people assigned to the company team should not meet with members of the company team in the other negotiation. Each negotiator may add facts that logically flow from the common fact sheet and from his or her individual facts; no negotiator may add facts that do not logically flow from the given facts.

June 27, 2011

Acting Comptroller John Walsh
Office of the Comptroller of the Currency
250 E Street, SW, Mail Stop 2-3
Washington, D.C.20219

Re: OTS Integration; Dodd-Frank Act Implementation,
Docket ID OCC-2011-0006,
RIN 1557-AD41

Dear Comptroller Walsh:

We, the undersigned state Attorneys General respectfully submit the following comments in response to the Office of the Comptroller of the Currency’s proposed regulations implementing the provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act.[1] The comments address our specific concerns about the preemption of state law and the exercise of state enforcement powers that are addressed in the proposed regulations.

Protection of consumers is a traditional state duty and power. Beginning with the 1999 enactment of North Carolina’s predatory mortgage lending law, states have been at the forefront of protecting consumers against abusive financial practices. The landmark mortgage lending settlements with First Alliance, Household Finance, Ameriquest and Countrywide returned hundreds of millions of dollars to victimized borrowers while forcing lenders to agree to significant reforms. At the outset of the subprime lending debacle, many states enacted new restrictions on subprime loan origination and documentation practices. These state-level reforms occurred before any similar action at the federal level, and paved the way for the new mortgage rules in the Dodd-Frank Act. More recently, state Attorneys General took the initiative in addressing mortgage servicing failures and are now cooperating with federal authorities to bring needed reforms to loan servicing and foreclosure processing.

Over the last decade, state Attorneys General have vigorously opposed the OCC’s aggressive campaign to preempt state consumer protection laws. In 2003, all 50 state Attorneys General filed comments on the OCC’s proposed preemption rules. Those rules attempted to preempt consumer protection laws that the states had enforced for years in the financial marketplace, including against national banks. Notwithstanding the unanimous objections of the Attorneys General, the OCC proceeded to promulgate preemption regulations that were sweeping in their breadth and in their disregard for the lawful role of the states. The OCC is now seeking to retain the broad preemption rules that the states opposed in 2003.

Congress has responded to the OCC’s overreaching, recognizing the importance of state law and state enforcement. As part of the Dodd-Frank Act, Congress restored and strengthened the states’ historic role. The Act not only affirms powers states have always had to enforce state laws against federally-regulated banks, it also gives states new powers, such as the ability to enforce regulations promulgated by the new Consumer Financial Protection Bureau. Congress enacted these reforms to encourage an active and effective law enforcement partnership between the states and federal financial agencies to the ultimate benefit of consumers and a free and fair marketplace.

Unfortunately, the OCC’s current proposal maintains the very same preemption rules that were rejected by Congress in Dodd-Frank and by the Supreme Court in Cuomo v. Clearing House Assn., L.L.C., 129 S. Ct. 2710 (2009). The OCC has not complied with the Congressional directive to thoroughly review its relationship with state law on case-by-case basis, in light of the Supreme Court’s decision in Barnett Bank v. Nelson, 517 U.S. 25 (1996),and the statutory language of Dodd-Frank. In our view, the OCC should demonstrate its compliance by withdrawing its preemption regulations completely.

The OCC’s 2004 Preemption Rules are Inconsistent with Dodd-Frank and the U.S. Supreme Court Barnett Standard and Should be Repealed.

With some minor tinkering, the proposed OCC rules basically reaffirm the broad preemption regulations promulgated by the OCC in 2004. This failure to withdraw the 2004 rules conflicts with the letter and intent of the Dodd-Frank Act.

Section 1044(a) of the Act explicitly states that the National Bank Act does not “occupy the field in any area of State law.” Instead, the OCC is required to examine each state law it wishes to preempt on a “case-by-case” basis in a “proceeding.” It must place substantial evidence on the record during this proceeding to support preemption. The OCC must also confer with the new Consumer Financial Protection Bureau to determine whether the law is substantially equivalent to other laws before it may apply this preemption decision to any other law.

Historically, while purportedly based on a conflict preemption analysis, the OCC’s 2004 preemption regulations attempted to annul many state laws as they applied to national banks. Although the OCC did not use the field preemption label, through these regulations the OCC attempted to assert field preemption over state law. Instead of overturning its field preemption approach, the OCC’s proposed amended rule disregards the balanced preemption requirements of the Dodd-Frank Act and preserves the 2004 rules. The OCC’s attempt to assert field preemption in 2004 was untenable then and is clearly unsupportable now after the direct Congressional mandate in the Act.

Although the OCC claims to use a “conflict preemption” analysis in its preemption determinations, the proposed regulations seek to maintain the broad preemption standard from the 2004 regulations in which the OCC attempted to essentially occupy the fields.[2] Specifically, the new regulations would retain 12 C.F.R. § 7.4007 (b), which states that “[a] national bank may exercise its deposit-taking powers without regard to state law limitations concerning” abandoned and dormant accounts, checking accounts, disclosure requirements, and other aspects of deposit-taking. The regulations would also retain 12 C.F.R. § 7.4008 (d), which states that “[a] national bank may make non-real estate loans without regard to state law limitations concerning” licensing, registration, loan-to-value ratios, credit reports, and other aspects of consumer lending. Both sections are in opposition to the provision in Dodd-Frank that the National Banking Act does not “occupy the field” in any area of state law, as well as DoddFrank’s requirement that preemption determinations be made on a “case-by-case” basis.

Perhaps the most serious error in the proposed regulations is the OCC’s attempt to minimize the impact of the “prevent or significantly interfere” preemption standard mandated by Dodd-Frank and the Supreme Court’s Barnett decision. Dodd-Frank divides state laws into two categories – ‘consumer financial laws’ and all other state laws. Consumer financial laws are ones that directly and specifically address the manner, content or terms of a financial transaction.[3] Consumer financial laws are preempted only if they discriminate against national banks or if they prevent or significantly interfere with a bank’s exercise of a federally-granted power.[4]

The OCC does not use the term “prevent or significantly interfere” in its proposed preemption regulations. The OCC prefers to generally reference the Barnett case and contends that the “prevent or significantly interfere” test is not the exclusive Barnett standard and that “other formulations of conflict preemption” are relevant.[5] However, the OCC does not have the discretion to continue to interpret Barnett to suit its own views of preemption. The Congressional mandate is that “prevent or significantly interfere” is the applicable standard. The OCC should correct its proposed regulation to ensure that it will apply the proper preemption test.

Furthermore, the OCC must review its existing preemption precedents in light of the “prevent or significantly interfere” standard required by Dodd-Frank. The OCC’s proposal notes that the current “obstruct, interfere, or condition” standard for preemption was drawn from “an amalgam of prior precedents relied upon by the Supreme Court in its decision in Barnett.”[6] Thus, “[t]o the extent any existing precedent cited those terms in our regulations, that precedent remains valid.”[7] The OCC is clearly attempting to maintain its current standard for preemption, in direct opposition to the requirements of the Dodd-Frank Act. Congress rejected the standard currently used by the OCC by specifically including the “prevent or significantly interfere” language from the Barnett decision.[8] By stating that precedents based on the “obstruct, interfere, or condition” language remain valid, the OCC is subverting the intention of Congress by essentially continuing to use the standard that was rejected by Dodd-Frank to preempt state consumer financial laws.

The Visitorial Powers Restrictions on State Enforcement Authority in the Proposed Regulations Do Not Comply with the Dodd-Frank Act and the Cuomo Decision.

Historically, the OCC has claimed that its visitorial powers prevent states from enforcing non-preempted state laws against national banks. Section 1047 of the Dodd-Frank Act now specifically authorizes state Attorneys General to bring actions against national banks to enforce any “applicable law,” notwithstanding the OCC’s visitorial powers.[9] The Act cites Cuomo v. Clearing House Assn., L.L.C., 129 S. Ct. 2710 (2009) as further authority for state enforcement powers. In Cuomo, the Court held that the visitorial powers regulations issued by the OCC exceeded the authority granted to the agency under the National Bank Act: “the Comptroller erred by extending the definition of ‘visitorial powers’ to include ‘prosecuting enforcement actions.’”[10] However, the OCC attempts to minimize and qualify the Dodd-Frank and Cuomo authorization of Attorney General enforcement in its proposed amendment to 12 C.F.R. § 7.4000 (a):

State officials may not exercise visitorial powers … such as … prosecuting enforcement actions, except in limited circumstances authorized by federal law.

This proposed “visitorial powers” restriction on state enforcement actions conflicts with Cuomo,which declared that such enforcement actions are not a visitorial power. Furthermore, under the Dodd-Frank Act, states may bring suit to enforce any “applicable law” whether or not there is a federal law that authorizes it. Thus, the Act does not condition state enforcement on authorization by federal law.

The proposed regulation also adds to the lists of visitorial powers: “investigatingor enforcing compliance with any applicable federal or state laws concerning those activities.”[11] Although the Supreme Court in Cuomo held that states may not enforce pre-litigation investigative subpoenas against national banks, it did not hold that every possible type of investigation is prohibited visitation. For example, states could collect complaints from consumers or research the public records without running afoul of the exclusive visitation provision of the NBA. Consequently, a broad rule prohibiting states from investigating compliance with applicable laws is unwarranted.

The OCC also leaves in place its existing visitorial powers definition, 12 CFR § 7.4000 (a) (2) (iv). This regulation prohibits state Attorneys General from enforcing compliance with any federal laws relating to national banks.[12] The regulation should be amended or withdrawn because, under the Dodd-Frank Act, state Attorneys General are authorized to enforce certain federal laws, as well as rules and regulations promulgated by the Consumer Financial Protection Bureau.[13]

The OCC Does Not Have Authority to Preempt General State Laws

The Dodd-Frank Act does not address general state laws such as a state consumer protection act. The preemption standard for general state laws as applied to national banks is declared in Barnett, which held that:

[i]n defining the pre-emptive scope of statutes and regulations granting a power to national banks … normally Congress would not want States to forbid, or to interfere significantly, the exercise of a power that Congress explicitly granted. To say this is not to deprive States of the power to regulate national banks, where … doing so does not prevent or significantly interfere with the national bank’s exercise of its powers.[14]

Thus, States retain their enforcement powers against national banks provided that enforcement does not prevent or significantly interfere with federally-authorized bank activities. Dodd-Frank also provides that nothing in its provisions may be interpreted to prevent state enforcement actions and proceedings under state law.[15] Therefore, states may bring state law enforcement actions of any kind against national banks, provided they do not prevent or significantly interfere with the powers granted to banks.

The Attorneys General take issue with any implication that the OCC has any power to preempt state laws that are not state consumer financial laws. As amended, the regulations would state that the list of non-preempted state laws includes:

Any other law that the OCC determines to be applicable to national banks in accordance with the decision of the Supreme Court in Barnett Bank of Marion County, N.A. v. Nelson, Florida Insurance Commissioner, et al. 517 U.S. 25 (1996), or that is made applicable by Federal law.[16]

This regulation appears to assert that state laws, other than those specifically listed, are preempted unless the OCC determines them to be applicable to national banks. However, in Dodd-Frank, Congress clarified where the OCC has the power to preempt state law and on what terms: it may preempt state consumer financial laws if, reviewed on a case-by-case basis, the law violates Barnett and prevents or significantly interferes with national banking activities.

Conclusion

The OCC’s insistence on maintaining its posture in favor of broad preemption of state law is disappointing and ignores a clear Congressional mandate to the contrary. To comply with the new statutory directives on the preemption of state law, the OCC must review state financial laws on a case-by-case basis to determine whether those laws prevent or significantly interfere with national bank powers. The OCC should not rely on its former general preemption pronouncements, which were based on an improper standard and have been rejected by Congress. With respect to enforcement, we believe that state and federal regulators should work together and share their respective authority to protect consumers and to ensure a fair financial marketplace.

Sincerely,
[Attorneys General of 47 States and the Northern Mariana Islands]

¹ Pub. L.No. 111-203, Tit. X, 1001-1100H, 124 Stat. 1376 (July 21, 2010) (hereinafter Dodd-Frank).

² The OCC’s notice of proposed rulemaking states that “under the Dodd-Frank Act, the proper preemption test is conflict preemption.” Office of Thrift Supervision Integration; Dodd-Frank Act Implementation, 76 Fed.Reg.30557, 30563 (proposed May 26, 2011).

³ Dodd-Frank at § 1044 (a).

⁴ Id.at §§1044 (a) and 1046 (a).

⁵ 76 Fed Reg. at 30563 (amending 12 C.F.R. §§ 7.4007©, 7.4008(e) and 34.4(a)).

⁶ Id.

⁷ Id.

⁸ A Senate report states that “the standard for preempting State consumer financial law would return to what it had been for decades, those recognized by the Supreme Court in Barnett Bank v. Nelson, 517 U.S. 25 (1996), undoing broader standards adopted by rules, orders, and interpretations issued by the OCC in 2004.” Sen. Comm. on Banking, Housing and Urban Affairs, S.Rep. No. 111-176, at 175 (2010).

fn9.“[N]o provision of this title which relates to visitorial powers … shall be construed as limiting or restricting the authority of any attorney general (or other chief law enforcement officer) of any State to bring an action against a national bank in a court of appropriate jurisdiction to enforce an applicable law and to seek relief as authorized by such law.” Dodd-Frank at § 1047 (a).

¹⁰ Cuomo at 2721.

¹¹ We do not object to the addition of the word “investigating” on the assumption that it does not refer to judicial investigations, such as litigation discovery permitted under the Cuomo decision.

¹² “[V]isitorial powers include: … Investigating or enforcing compliance with any applicable federal or state laws concerning those activities.” (“those activities” refers to activities authorized by federal banking laws.) proposed§ 7.4000 (a) (2) (iv).

¹³ “The attorney general … of any State may bring a civil action in the name of such State against a national bank or Federal savings association… to enforce a regulation prescribed by the Bureau under a provision of this title.” DoddFrank § 1042(a)(2)(B). Even prior to the Dodd-Frank Act, state Attorneys General were authorized to enforce provisions of other federal consumer financial laws against national banks, such as the Truth in Lending Act, 15 U.S.C. § 1640 (e), or the Real Estate Settlement Procedures Act, 12 U.S.C. § 2601(d) (4).

¹⁴ Barnett at 33.

¹⁵ Dodd-Frank at § 1042 (d).

They Warned Us: The Watchdogs who Saw the Subprime Disaster Coming–and How they were Thwarted by the Banks and Washington

By Robert Berner and Brian Grow

More than five years ago, in April 2003, the attorneys general of two small states traveled to Washington with a stern warning for the nation’s top bank regulator. Sitting in the spacious Office of the Comptroller of the Currency, with its panoramic view of the capital, the AGs from North Carolina and Iowa said lenders were pushing increasingly risky mortgages. Their host, John D. Hawke Jr., expressed skepticism.

Roy Cooper of North Carolina and Tom Miller of Iowa headed a committee of state officials concerned about new forms of “predatory” lending. They urged Hawke to give states more latitude to limit exorbitant interest rates and fine-print fees. “People out there are struggling with oppressive loans,” Cooper recalls saying.

Hawke, a veteran banking industry lawyer appointed to head the OCC by President Bill Clinton in 1998, wouldn’t budge. He said he would reinforce federal policies that hindered states from reining in lenders. The AGs left the tense hour-long meeting realizing that Washington had become a foe in the nascent fight against reckless real estate finance. The OCC “took 50 sheriffs off the job during the time the mortgage lending industry was becoming the Wild West,” Cooper says.

This was but one of many instances of state posses sounding early alarms about the irresponsible lending at the heart of the current financial crisis. Federal officials brushed aside their concerns. The OCC and its sister agency, the Office of Thrift Supervision (OTS), instead sided with lenders. The beneficiaries ranged from now-defunct subprime factories, such as First Franklin Financial, to a savings and loan owned by Lehman Brothers, the collapsed investment bank.

Some states, including North Carolina and Georgia, passed laws aimed at deterring rash loans only to have federal authorities undercut them. In Iowa and other states, mortgage mills arranged to be acquired by nationally regulated banks and in the process fended off more-assertive state supervision. In Ohio the story took a different twist: State lawmakers acting at the behest of lenders squelched an attempt by the Cleveland City Council to slow the subprime frenzy. A number of factors contributed to the mortgage disaster and credit crunch. Interest rate cuts and unprecedented foreign capital infusions fueled thoughtless lending on Main Street and arrogant gambling on Wall Street. The trading of esoteric derivatives amplified risks it was supposed to mute.

One cause, though, has been largely overlooked: the stifling of prescient state enforcers and legislators who tried to contain the greed and foolishness. They were thwarted in many cases by Washington officials hostile to regulation and a financial industry adept at exploiting this ideology.

The Bush Administration and many banks clung to what is known as “preemption.” It is a legal doctrine that can be invoked in court and at the rulemaking table to assert that, when federal and state authority over business conflict, the feds prevail—even if it means little or no regulation.

“Fundamental Disagreement”

“There is no question that preemption was a significant contributor to the subprime meltdown,” says Kathleen E. Keest, a former assistant attorney general in Iowa who now works for the Center for Responsible Lending, a nonprofit in Durham, N.C. “It pushed aside state laws and state law enforcement that would have sent the message that there were still standards in place, and it was a big part of the message to the industry that it could regulate itself without rules.”

“That’s bull——,” says Hawke, the former comptroller. He returned to private law practice in late 2004 with the prominent Washington firm Arnold & Porter. Once again representing lenders as clients, he confirms the substance and tone of the April 2003 meeting with the state AGs, saying they “simply had a fundamental disagreement.” But he denies that federal preemption played a role in the subprime debacle.

Hawke blames much of the mess on mortgage brokers and originators who, he says, were the responsibility of states. “I can understand why state AGs would try to offload some responsibility here,” he adds. “It’s important to remember when people are trying to assign blame here that the courts uniformly upheld our position.”

His arguments have some merit. The federal judiciary has bolstered preemption in the name of uniform national rules, not just for banks but also for manufacturers of drugs and consumer products. And state oversight alone is no panacea, as the chaotic state-regulated insurance market illustrates. Inadequate supervision of mortgage companies in some states contributed to the subprime explosion. But the hands-off signals sent from Washington only invited complacency. When some state officials fired warning flares, the Administration doused them.

Consider a clash in 2004 between the OCC and regulators in Michigan. In January of that year attorneys working for Hawke filed a brief in federal court in Grand Rapids on behalf of Wachovia, the national bank with $800 billion in assets based in Charlotte, N.C. Michigan wanted to continue to examine a Wachovia-controlled mortgage unit in the state, which the bank had converted to a wholly owned subsidiary. The parent bank sued, claiming Michigan could no longer look at the mortgage lender’s books. Citing the threat of unspecified “hostile state interests,” the OCC argued in its brief that “states are not at liberty to obstruct, impair, or condition the exercise of national bank powers, including those powers exercised through an operating subsidiary.”

Michigan countered that Wachovia Mortgage was not itself a national bank. The Constitution preserves state authority to protect its residents when federal statutes don’t explicitly bar such regulation, Michigan contended. Ken Ross, the state’s top financial regulator, says his department fought Wachovia all the way to the U.S. Supreme Court in part because it feared a growing subprime mortgage problem: “We knew there needed to be [state] regulation in place or there could be gaps.” The OCC, he adds, “did not have robust regulatory provisions over these operating subsidiaries.”

The nation’s highest court sided with the Bush Administration, ruling in April 2007 that the OCC had exclusive authority over Wachovia Mortgage. Justice Ruth Bader Ginsburg, writing for a five-member majority, pointed to the potential burdens on mortgage lending if there were “duplicative state examination, supervision, and regulation.” In a dissenting opinion, Justice John Paul Stevens said that it is “especially troubling that the court so blithely preempts Michigan laws designed to protect consumers.”

By the time of the Supreme Court decision last year, Wachovia and its mortgage operations in Michigan and elsewhere were feeling the ill effects of unwise lending. As real estate prices continued to fall this year, pushing many borrowers into default, Wachovia teetered on the edge of failure. In late September the federal government stepped in to arrange a fire sale. Wachovia now may be carved up between Citigroup and Wells Fargo.

Confrontations such as Michigan’s battle with Wachovia became far more common after George W. Bush took over the White House in 2001 and instituted a broad deregulatory agenda. The OCC, an arm of the Treasury Dept., has adhered closely to it. The agency oversees more than 1,700 federally chartered banks, controlling two-thirds of all U.S. commercial bank assets. Historically, its examiners have monitored bank capital levels and lending to corporations more attentively than they have the treatment of individual borrowers. “Consumer protection has always been an orphan [among federal bank regulators],” says Adam J. Levitin, a commercial law scholar at Georgetown University Law Center.

The OCC brought 495 enforcement actions against national banks from 2000 through 2006. Thirteen of those actions were consumer-related. Only one involved subprime mortgage lending. OCC spokesman Robert Garsson says the figures could be misinterpreted because the agency addresses many problems informally during bank examinations. He declined to provide any examples.

Beyond the influence of free-market theory, turf concerns have reinforced the Administration’s determination to exercise responsibility for as many lenders as possible—and prevent state incursions, notes Arthur E. Wilmarth Jr., a professor at George Washington University Law School. Almost all of the funding for the OCC and OTS comes from fees paid by nationally chartered institutions.

Georgia Fight

Hawke says the OCC seeks only to exercise powers that it has long held under federal law. It is far more efficient for national banks to deal with one set of federal rules than a hodgepodge of state directives, he argues, echoing the Supreme Court’s majority view. By the late 1990s, he adds, more state legislatures and AGs were trying to bully national banks by, for example, restricting ATM fees charged to nondepositors. State officials “found it politically advantageous to assert these kinds of initiatives,” he says. The OCC’s heightened preemption campaign “was occasioned by the fact the states were becoming more aggressive.”

The current head of the OCC, John C. Dugan, concurs. “To claim that it is our fault from preemption is just a total smokescreen to shield the fact that the state mortgage brokers and mortgage companies were just not regulated,” Dugan says.

Efforts in Georgia to rein in unwise lending provoked a particularly fierce federal reaction. In 2002 the state passed a law that imposed “assignee liability” on the mortgage-finance process. Understanding the significance of this requires a little background.

One of the forces that accelerated the proliferation of dangerous home loans was the Wall Street business of buying up millions of mortgages, bundling them into bonds, and selling the securities to pension funds and other investors. Securitization, which grew to a $7 trillion industry, meant the lenders could pass along the risk of default to a huge universe of investors. Many of those investors, in turn, relied uncritically on reassurances from fee-collecting investment banks and ratings agencies that mortgage-backed securities were high-quality. When many of the reassurances proved hollow, the securitization market collapsed this year.

Assignee liability would radically reshape that market by making everyone involved potentially responsible when things go bad. Investment banks that created mortgage-backed securities and investors who bought them would be liable for financial damage if mortgages turned out to be fraudulent. The financial industry opposed assignee liability, maintaining that it would cripple the market for asset-backed securities. Major ratings agencies later agreed that allowing unlimited damages would be disruptive. The agencies threatened to stop evaluating many bonds tied to mortgages covered by the Georgia law.

But some banking experts speculate that if Georgia’s example had spurred more states to adopt broad assignee liability, greater caution would have prevailed in the mortgage-securities market, possibly preventing the blowups of Lehman, Bear Stearns, and other once-mighty institutions. “If the Georgia law had held, it is possible that other states would have followed and there might have been change earlier,” says Ellen Seidman, who headed the OTS from 1997 through 2001.

“Outgunned” Advocates

Roy Barnes, Georgia’s governor in 2002, understood the potential significance of assignee liability when he signed the state’s new Fair Lending Act that year. He recalls a breakfast meeting with banking lobbyists during which he admonished the industry to clean up reckless lending. He jokingly threatened to hire “the longest-haired, sandal-wearing bank commissioner you ever saw.” But the bankers fought back, seeking to undermine the new law.

The OCC’s Hawke assisted the industry by issuing a ruling in July 2003 saying the Georgia law did not apply to national banks or their subsidiaries. A fact sheet prepared at the time—and still available on the OCC’s Web site—says: “There is no evidence of predatory lending by national banks or their operating subsidiaries, in Georgia or elsewhere.” The OCC ruling had been requested by Cleveland-based National City Bank on behalf of several of its units, including First Franklin Financial, a subprime lender that operated in Georgia and other states. First Franklin, which was acquired by Merrill Lynch in 2006, has been hit with dozens of suits alleging unfair lending practices. Merrill shut down First Franklin’s troubled lending business in March. Itself hobbled by mortgage-securities losses, Merrill agreed last month to be acquired by Bank of America. The bank and Merrill declined to comment.

In August 2004, Hawke went a step further in a letter to the Georgia Banking Dept. He said even state-chartered mortgage brokers and lenders were exempt from the Georgia law—if the loans they handled were funded at closing by a national bank or its subsidiary.

By then support for the Georgia law was already eroding. Barnes, a Democrat, lost his reelection campaign in November 2002, and his Republican successor moved to dilute the lending act. Still, supporters mobilized to defend the legislation. One was William J. Brennan Jr., an Atlanta legal aid attorney who specializes in housing and had testified before the U.S. Congress in 2000 about what he saw as the looming mortgage mess. He told the House Financial Services Committee: “The entry of many prominent national banks into the subprime mortgage-lending business has resulted not in reform, but in the expansion of the abusive practices.” Federal regulators, he testified, “have done little to stop” the trend. In early 2003, Brennan and a legal aid colleague, Karen E. Brown, consulted with Georgia legislators trying to block amendments softening the lending law. At a hearing in February, Brennan requested a police escort because he feared that angry mortgage brokers would block his way. “The words that come to mind are ‘outgunned’ and ‘overwhelmed,’” says Brown.

The Georgia legislature sharply curtailed the assignee liability provision in March 2003 and eliminated other elements of the law as well. Subprime lenders such as Ameriquest Mortgage that had halted lending in Georgia in protest of the law resumed marketing high-interest, high-fee mortgages. But by late 2007, Ameriquest had gone out of business after agreeing to a $325 million settlement to resolve suits alleging that it had made fraudulent loans.

Escaping State Enforcement

Georgia now has the sixth-highest rate of foreclosure in the country. Consumer advocates and state attorneys general contend the weakening of the state’s law was a severe blow to efforts to curb careless lending. “Had the Georgia Fair Lending Act not been watered down, we would be in a very different place right now,” says Brown.

In some states, dubious local mortgage firms sold themselves to national banks, gaining protection against state enforcement. The Iowa Division of Banking in 2006 sought to examine a subprime broker called Okoboji Mortgage in the town of Arnolds Park. A borrower had accused the firm (named for an area lake) of duplicitous lending practices. Cheryl Riley, a 52-year-old janitor, told state officials she had not received the 30-year fixed-rate mortgage she thought she had arranged with Okoboji in 2005. Instead of one monthly statement, Riley got two: one for a 9.25% adjustable-rate loan and another for a 15-year fixed loan at 12%. Both rates were far higher than what Riley and her husband thought they had negotiated. “We were horrified,” she says.

A preliminary state investigation found that Okoboji’s manager had headed a mortgage firm in Nebraska that lost its license for falsifying loan documents. But Okoboji refused Iowa’s demand for an examination, forcing the agency to file suit in August 2006. Okoboji responded by announcing that it had been acquired by Wells Fargo, a nationally chartered bank regulated by the OCC. Okoboji handed in its state license, saying it no longer had to comply with Iowa rules. “We’d had red flags but were now blocked from investigating,” says Shauna Shields, an Iowa assistant AG.

Okoboji’s former manager, Lyda Neuhaus, calls Nebraska’s earlier actions “a witch hunt” based on “12 miserable complaints.” Her father, Juan Alonso, who owned Okoboji, says he sold his company because he wanted to retire, not to escape state regulation. Both deny any wrongdoing. A Wells Fargo spokesman declined to comment on Iowa’s concern about Okoboji and defended the acquisition as benefiting customers and shareholders.

“Playing Field with no Rules”

The experience with Okoboji was the sort of thing that Iowa AG Miller had warned about when he joined his counterpart from North Carolina on their visit to OCC chief Hawke in 2003. “Now, we could not do anything with federally chartered banks or subsidiaries,” Miller says. In 2006 and 2007 the Iowa legislature shot down proposals by Miller for morerestrictive lending laws. Lax regulatory standards at the federal level helped undermine his efforts, he explains. Statechartered banks insisted that tougher rules in Iowa would put them at a competitive disadvantage with federally chartered banks overseen by the OCC. “We had to acknowledge the [political] environment we were in,” Miller says.

The banking industry repeated the argument for regulatory “parity” in many states that tried and failed to tighten supervision of subprime lenders, says Keest of the Center for Responsible Lending: “State institutions then wanted a level playing field, which was a playing field with no rules.”

Hawke says that it would have been inappropriate for the states to impose more-stringent standards on federally chartered institutions: “Had they tried to apply those rules to national banks, they clearly would have been preempted.”

In Cleveland in 2002, Frank G. Jackson, then a member of the City Council, could see that many lower-income residents were being persuaded by lenders to pile on high-interest debt. “It was pure greed, based on exploitation,” he says. “[Some subprime lending] is just the same as organized crime.” He started negotiating with mortgage lenders for more favorable terms. To his surprise, the lenders bypassed him and persuaded the state legislature to enact a less stringent version of an anti-predatory lending act he was drafting. “I figured the good faith had ended, so I passed my law [at the city level],” Jackson says. That law required lenders to register with the city and provided counseling to prospective borrowers.

His accomplishment was short-lived. That same year, the American Financial Services Assn. (AFSA), a national trade group, sued to block Ohio municipalities from passing lending laws that conflicted with state statutes. The Ohio Supreme Court later sided with the industry. AFSA’s goal was to ward off conflicts between federal, state, and local rules, says spokesman Bill Himpler. “Different municipalities moving different anti-predatory lending legislation . . .would have brought the credit markets to a screeching halt.”

Fulfilling Jackson’s fears, the Cleveland area has become one of the places worst hit by the mortgage catastrophe. More than 80,000 homes have gone into foreclosure since 2000, the highest per capita rate in the country.

In January, Jackson, elected the city’s mayor in 2005, tried a new tactic. He filed suit in state court against Lehman, Wells Fargo, and 19 other lenders, alleging that they sold “toxic subprime mortgages . . . under circumstances that made the resulting spike in foreclosures a foreseeable and inevitable result.” The city’s attorneys based the suit on an Ohio law banning “public nuisances,” which is usually used against defendants such as manufacturers whose factories emit pollution. The idea was to steer clear of conventional banking law and head off any claim of federal preemption. The suit is pending; the banks all deny wrongdoing.

Consumer bureau’s Richard Cordray, from state regulator to federal enforcer

By Brady Dennis

The tall, soft-spoken man pad-ding around the fifth floor of 1801 L St. — often not wearing shoes and occasionally quoting Shakespeare — seems at first more like a college professor than a hard-charging enforcer. But he holds what soon could become a powerful post in Washington’s changing financial regulatory landscape, a prospect that has heartened consumer advocacy groups and deepened the concerns of an already skeptical financial industry.

Just months ago, Richard Cordray was Ohio’s attorney general. In that role, he sued some of the nation’s largest banks for their bungling of mortgage foreclosures, spoke of Wall Street as a “fixed casino” and became a leading advocate for the creation of the federal Consumer Financial Protection Bureau.

Today, he is the chief enforcement officer for the fledgling watchdog. When the bureau officially opens this summer, Cordray will head a federal team with wide authority to write and enforce rules that will govern many of the firms that he butted heads with as a state official.

“It offered a possibility to continue to do some of the most important work I felt I was doing as a state attorney general,” Cordray said in a recent interview in his new office in Washington, “and in many respects, on a better footing, from a better foundation, with better tools, better authority and on a 50-state basis.”

Many state attorneys general, who have complained that their efforts to enforce stricter consumer protections have been stymied by federal regulators over the years, have echoed consumer advocates in cheering Cordray’s appointment.

“He’s got a gold-plated resume and a wealth of experience. . . . He’s very reasonable, he’s very smart, he’s very fair,” said Illinois Attorney General Lisa Madigan. “He understands the financial, the economic, the fiscal things, as well as the law enforcement side of it. . . . To me, that’s the type of person you want in that position.”

Representatives of the banking industry have reacted with far less enthusiasm, saying they fear that Cordray will overreach in his new role and burden them with un-necessary new oversight.

“Richard Cordray was known as sort of a regulatory zealot in Ohio and generally was pretty tough on the financial services industry within his state,” said Camden Fine, head of the Independent Community Bankers of America, echoing others in the financial industry who were reluctant to speak publicly. “We have concerns about how he will handle enforcement of CFPB regulations and the new rules that the CFPB will be pumping out. . . . The jury is still out.”

The 51-year-old Ohio native took a circuitous, and in many ways accidental, path on his way to becoming a Washington regulator, including a law degree from the University of Chicago, a stint as a clerk for Supreme Court Justice Anthony M. Kennedy and a five-day run as a “Jeopardy” champion in the late 1980s.

After losing races for the U.S. House and Senate, Cordray won a special election in 2008 to replace Attorney General Marc Dann, who left during the middle of his term after a sexual harassment scandal. Well before the “robo-signing” issue triggered a national furor last fall, Cordray aggressively went after financial firms for what he perceived as fraudulent and shoddy mortgage servicing and foreclosure practices.

In 2009, he sued multiple-loan servicing companies, alleging that they had violated state consumer laws. Last year, he filed suit against GMAC Mortgage and its parent company, Ally Financial, alleging fraudulent, unfair and deceptive practices. Along the way, he lobbied for the creation of the CFPB, which had become a controversial topic in Washington.

Several days after he lost his bid for reelection in November, part of a wave of Republican victories in Ohio, Cordray got a call from Elizabeth Warren, the Harvard law professor appointed by President Obama to set up the new bureau. “I just really hadn’t given much thought to anything yet, and here she was recruiting me,” he said. “It was unexpected.”

Despite his initial reservations about seeing his wife and 12-year-old twins back in Ohio only on weekends, Cordray agreed to join the new bureau. “Richard Cordray has the vision and experience to help us build a team that ensures every lender in the marketplace is playing by the rules,” Warren said in a December statement announcing Cordray’s hire.

These days, Cordray’s time is a mixture of looking at the big picture and small details. For every meeting about changes to mortgage-servicing practices — an issue he still cares about intensely — there are personnel issues that demand attention. Questions about the bureau’s overall enforcement philosophy compete with questions about IT systems and office space.

“It kind of goes in fits and starts,” Cordray said. “But you can see progress. .•.•. Getting off to a good start with this bureau will set it on a good footing for years to come.”

In December, he was quoted in a Columbus Dispatch article saying he intends to run for governor of Ohio in 2014. But ensconced in his small office on L Street, he now takes a more measured approach about his political future.

“Someday, if and when I’m no longer here, I will think about that again,” he said. “In the meantime, I’ve had to put that to the side and focus on my job here. And I’m totally happy with that.”

Eyes Open, WaMu Still Failed

By Floyd Norris

In the crazy days of 2005 and 2006, when home prices were soaring and mortgage underwriting standards were crumbling, it took foresight and judgment to see that it was all a bubble.

As it happens, there was a bank chief executive whose internal forecasts now seem prescient. “I have never seen such a high-risk housing market,” he wrote to the bank’s chief risk officer in 2005. A year later he forecast the housing market would be “weak for quite some time as we unwind the speculative bubble.”

At that same bank, executives checking for fraudulent mortgage applications found that at one bank office 42 percent of loans reviewed showed signs of fraud, “virtually all of it attributable to some sort of employee malfeasance or failure to execute company policy.” A report recommended “firm action” against the employees involved.

In addition to such internal foresight and vigilance, that bank had regulators who spotted problems with procedures and policies. “The regulators on the ground understood the issues and raised them repeatedly,” recalled a retired bank official this week.

This is not, however, a column about a bank that got things right. It is about Washington Mutual, which in 2008 became the largest bank failure in American history.

What went wrong? The chief executive, Kerry K. Killinger, talked about a bubble but was also convinced that Wall Street would reward the bank for taking on more risk. He kept on doing so, amassing what proved to be an almost unbelievably bad book of mortgage loans. Nothing was done about the office where fraud seemed rampant.

The regulators “on the ground” saw problems, as James G. Vanasek, the bank’s former chief risk officer, told me, but the ones in Washington saw their job as protecting a “client” and took no effective action. The bank promised change, but did not deliver. It installed programs to spot fraud, and then failed to use them. The board told management to fix problems but never followed up.

WaMu, as the bank was known, is back in the news because the Federal Deposit Insurance Corporation sued Mr. Killinger and two other former top officials of the bank last week, seeking to “hold these three highly paid senior executives, who were chiefly responsible for WaMu’s higher-risk home-lending program, accountable for the resulting losses.”

Mr. Killinger responded by going on the attack. His lawyers called the suit “baseless and unworthy of the government.” Mr. Killinger, they said, deserved praise for his excellent management.

I’ll let the courts sort out whether Mr. Killinger will become the rare banker to be penalized for making disastrously bad loans. But I am fascinated by how his bank came to make those loans despite his foresight.

Answers are available, or at least suggested, in the mass of documents collected and released by the Senate Permanent Subcommittee on Investigations, which held hearings on WaMu last year. Mr. Killinger wanted both the loan book and profits to rise rapidly, and saw risky loans as a means to those ends.

Moreover, this was a market in which a bank that did not reduce lending standards would lose a lot of business. A decision to publicly decry the spread of high-risk lending and walk away from it — something Mr. Vanasek proposed before he retired at the end of 2005 — might have saved the bank in the long run. In the short run, it would have devastated profits.

Ronald J. Cathcart, who became the chief risk officer in 2006, told a Senate hearing he pushed for more controls but ran into resistance. The bank’s directors, he said, were interested in hearing about problems that regulators identified over and over again. “But,” he added, “there was little consequence to these problems not being fixed.”

There were consequences for him. He was fired in 2008 after he took his concerns about weak controls and rising losses to both the board and to regulators from the Office of Thrift Supervision.

By early 2007, the subprime mortgage market was collapsing, and the bank was trying to rush out securitizations before that market vanished. The Federal Deposit Insurance Corporation, a secondary regulator, was pushing to impose tighter regulation, but the primary regulator, the Office of Thrift Supervision, was successfully resisting allowing the F.D.I.C. to even look at the bank’s loan files.

In June of that year, amid evidence that home prices were falling in some of the areas of California and Florida where WaMu had its greatest concentration of loans, Mr. Killinger was crowing that he had been right. “For the past two years, we have been predicting the bursting of the housing bubble,” he wrote in a memo to the company’s directors. “That scenario has now turned into a reality.”

That was, however, no reason to turn his back on the high-risk loans. Instead, he wanted to keep more such loans for the bank, rather than sell them in securitizations. He viewed WaMu as overcapitalized by $7 billion and said reducing its capital — and attractiveness to a potential acquirer — was a “must do.”

In Washington, concern over highly risky mortgages had been growing, and in 2006 regulators issued guidance about them. The Office of Thrift Supervision fought to weaken the guidance, and when it met with WaMu after the guidance came out, its officials told the bank not to worry.

“They specifically pointed out,” a WaMu official wrote in a memo after meeting with regulators, “that the language in the guidance says ‘should,’ vs. ‘must’ in most cases and they are looking to WaMu to establish our own position of how the guidance impacts our business processes.”

As things got worse and worse in 2008, the regulators resisted taking any enforcement action, despite pleas by the F.D.I.C. Finally, on July 3, John M. Reich, director of the Office of Thrift Supervision, notified Mr. Killinger that they would take harsher action than the bank had wanted, by requiring the bank to sign a memorandum of understanding. He did so in an apologetic e-mail, saying he had written only after Mr. Killinger failed to return a couple of phone calls.

Mr. Reich promised the action would be kept confidential, and said action was needed in part because “if someone were looking over our shoulders, they would probably be surprised” the regulator had not acted long before.

By then it was too late. After Lehman Brothers failed in September, depositors fled and the bank was closed. The vast majority of its loans were based on “stated income,” and it turned out that there were more than a few liars among the borrowers. Its $178 billion in mortgage loans went to JPMorgan Chase, which promptly concluded that about two-thirds of them were impaired. It took a $30 billion write-down, but that proved inadequate. It has written off another $5 billion since.

The Dodd-Frank law abolished the Office of Thrift Supervision, in part because of the WaMu failure.

To Carl Levin, the Michigan senator who heads the subcommittee that investigated WaMu, a lesson is that “you need cops on the beat.” I doubt it is that simple. There were cops at the thrift office, and the ones on the ground found lots of problems that their bosses did little about. There were also cops inside WaMu. But they were neutered, ignored and eventually pushed aside. The board passed appropriate resolutions, but did nothing to stop the rot.

A few decades ago, I recall the chairman of one large bank explaining why his bank had joined in the lending folly of that era — lending to developing countries that needed money to pay rising oil prices.

If his bank had not joined in, he said, business would have gone elsewhere, and his bank would no longer have been a major lender.

So it was with WaMu. It had identified Countrywide Financial as a model to emulate, and any other course would have surrendered market share, not to mention the immediate profits that financed huge paychecks for executives.

Was that illegal? A court will decide, assuming no settlement is reached. Perhaps a judge will be impressed by all the formalities that Mr. Killinger’s lawyers listed in rising to his defense:

“Washington Mutual’s management structure was a model of corporate governance,” they wrote. “The mortgage lending practices of the bank were established by a professional corps of bankers and risk managers with extensive experience in home lending. Those practices were in turn carefully reviewed and monitored by independent credit risk management and board committees. An internal audit group similarly reported directly to an audit committee of the board to assure compliance with law and management objectives. The work of the management and board committees were, in turn, subject to continuous review and scrutiny by outside auditors and, perhaps most importantly, by federal bank regulators.”

Senator Levin’s view of the bank is more pithy.

“It was a model,” he said, “of corporate ineptitude, greed and wrongdoing.”