A federal thrift regulator bungled its oversight of Downey Savings & Loan, allowing the Newport Beach thrift to pile on billions of dollars in high-risk mortgages and eventually collapse, according to a government report.

The regulators from the beleaguered Office of Thrift Supervision also botched their oversight of Pomona-based PFF Bank & Trust, which collapsed along with Downey last fall, according to reports issued this week by the U.S. Treasury Department’s inspector general.

The Obama administration proposed Wednesday that the OTS, which has long been criticized as weak and ineffectual, be abolished. As part of his overhaul of financial regulation, Obama recommended that savings and loans, which have been principally mortgage lenders, answer to the same regulators as full-service commercial banks that specialize in a range of loans to businesses as well as consumers.

“We’ve seen that structural deficiencies allow some companies to shop for the regulator of their choice,” Obama said. “And that’s why, as part of these reforms, we will dismantle the Office of Thrift Supervision and close loopholes that have allowed important institutions to cherry-pick among banking rules.”


This week’s reports are only the latest critical looks at failed thrifts supervised by the OTS. After the Federal Deposit Insurance Corp. spent $10.7 billion to back deposits at Pasadena’s failed IndyMac Bank, the inspector general said in February that OTS examiners ignored repeated warning signs of trouble with exotic mortgages and allowed the thrift to backdate a cash infusion to make it seem stronger.

The Downey failure attracted special attention because it was a major purveyor of one of the riskiest types of home loans: the pay-option adjustable-rate mortgage, which allowed borrowers to pay so little that their loan balances went up instead of down. These option ARMs, often written without checking borrowers’ earnings or assets, emerged as a major contributor to the nation’s foreclosure crisis.

The inspector general said Downey’s problems stemmed not only from issuing option ARM loans and subprime mortgages to people with bad credit but also from having inadequate systems to monitor risk and a high turnover among managers. Downey’s executives frequently failed to respond to recommendations from the OTS, the report said.

The final straw was the bursting of California’s housing bubble. Downey had counted on borrowers’ being able to refinance adjustable-rate loans before the payments shot higher. But as borrowers’ home values sank far below the amount of their mortgages, they were unable to do so and defaulted in higher numbers.


So many of the loans went sour that by November 2008, when Downey was taken over by regulators, the bank had lost $548 million in just nine months. OTS officials closed PFF the same day.

It was clear by 2002 that Downey was heavily involved in high-risk loans, according to the Treasury report, and examiners began warning Downey’s management that year of potential problems.

Yet despite the warnings, “OTS examiners did not require Downey to limit concentrations in higher-risk loan products,” the report said.

“We believe that in light of the OTS’s repeated expressions of concern and management’s unresponsiveness to those concerns, OTS should have been more forceful, at least by 2005, to limit such concentrations,” the report said.


Even after Downey, operated by parent Downey Financial Corp., was downgraded in the confidential regulatory ratings from a strong institution to an average one in 2006, the OTS took only an informal enforcement action against the thrift. The agency’s guidelines required a formal enforcement action, the report said.

OTS spokesman William Ruberry said Wednesday that the agency, after conducting its own internal review, agreed with the inspector general’s report on Downey. The report found that the OTS’ enforcement was strong in some respects and that the agency “appropriately used its authority to address Downey’s capital levels,” Ruberry said in an e-mailed statement.

U.S. Bancorp acquired Downey and PFF in November in a deal brokered by the FDIC, which said Downey’s collapse would cost the deposit insurance fund about $1.4 billion and PFF’s failure an additional $729 million.

Several large OTS-supervised thrifts, including Washington Mutual Inc., IndyMac and Downey, failed after suffering large losses on option ARMs and other risky loans.


The portfolios of two other major option ARM lenders overseen by OTS, Golden West Financial Corp. of Oakland and Countrywide Financial Corp. of Calabasas, also have racked up huge losses.

Countrywide, which switched from a more stringent banking regulator to the OTS in 2007 by becoming a thrift, is now part of Bank of America Corp. Golden West, parent of World Savings, was bought by Wachovia Corp., which failed and was taken over by Wells Fargo & Co.

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scott.reckard@latimes.com