Did AIG Find the Dumbest Regulator in Town?

There’s a reason why convicted criminals can’t vote. If they were allowed to choose the sheriff, who would be elected? The result would look like Dickens’ London, with Fagin running the show.

Yet this is exactly how major financial institutions have been allowed to game the system: by choosing their own regulator, state or federal, and in some cases playing musical chairs with federal regulators. One of the worst offenders: American International Group (AIG).

While everyone points fingers at everyone else, arguably the decision that brought down this trillion-dollar company and the world’s largest insurer, was made in June 1999 when then Chief Executive Maurice (Hank) Greenberg bought a Newport Beach, California savings and loan. This move, seemingly innocent, brought AIG, and ultimately its troubled Financial Products unit, under the control of the U.S. Office of Thrift Supervision (OTS).

From then on, AIG’s Financial Products unit acted with blinding speed. Using its London-based office run by Joseph Cassano, AIG wracked up more than $2 trillion in risky credit default swaps, creating a crisis that ultimately brought down the company in 2008.

And what did the OTS do? For that matter, what did the OTS even know? It regulates mom and pop thrifts, not sophisticated trading operations run out of overseas offices. It would be interesting to learn how many OTS officials ever visited AIG’s London offices between 2000 and 2008. It wasn’t until March 2008, nearly a month after the crisis hit the media, when the OTS sent a letter to AIG saying that it was downgrading units of the company.

“Many different aspects proved inadequate,” said Federal Reserve Chairman Ben Bernanke in testimony describing the OTS before Congress.

Inadequate is a polite word to describe the OTS, said Cumberland Advisors. “The OTS also gave us Countrywide, IndyMac and Superior S&L, just to mention a few failures of regulatory oversight,” said the investment money management firm in a market commentary.

The head of the OTS resigned in February, leaving Acting Director Scott Polakoff to take the heat in front of Congress. Polakoff admitted to a Senate Banking Committee that “In hindsight, the OTS should have directed (AIG) to stop originating credit default swap products before December 2005.” Then suddenly Polakoff was gone, placed on leave pending the results of an investigation into his agency’s role in allowing several banks to falsify financial statements.

Ultimately the past is prolog. Treasury Secretary Timothy Geithner and others are considering a “super-regulator” at the federal level who can deal with AIG-type problems. But too many regulators can spoil the broth, particularly if smart but unethical companies like AIG can pick and choose the dumbest regulator in town.