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Extra11/10/2008 12:01 AM ET

Was AIG watchdog not up to the job?

Because it owned a savings and loan, the insurance giant fell under the authority of the Office of Thrift Supervision, which was slow to recognize the company's complex risks.

By Jeff Gerth, ProPublica

U.S. regulators responsible for supervising American International Group (AIG, news, msgs) now acknowledge that they failed to grasp the impact of provisions in the complex derivative contracts that pushed the world's largest insurance company to the brink of collapse.

Terms of the insurancelike contracts, called credit-default swaps, required AIG to post billions of dollars in collateral in the event of a market slide or credit downgrade.

"We missed the impact" of the collateral triggers, said C.K. Lee, who ran a little-known team in the U.S. Office of Thrift Supervision, or the OTS, which oversaw AIG's finance unit. He said the swaps were viewed as "fairly benign products" until they overwhelmed the trillion-dollar company.

The government announced this morning that it had restructured and expanded its aid package for AIG, bringing the total to $150 billion in loans and investments.

Though Lee's team had red-flagged the AIG unit that handled swaps, sampled some of the contracts and knew about collateral provisions, no one recognized the extent of the risk, he said.

Instead, examiners mostly concurred with the company's repeated assurances that any risk in the swaps portfolio was manageable. They went along in part because of AIG's huge capital base, Lee said, and because securities underlying the swaps had top credit ratings.

"We were looking at the underlying instruments and seeing them as low-risk," he said. "The judgment the company was making was that there was no big credit risk."

Lee's comments offer the most detailed insight to date of the role U.S. supervisors played in advance of the biggest financial rescue in history. They also highlight how the OTS, mainly a savings-and-loan regulator, may have been miscast as watchdog for a huge global conglomerate.

Because AIG bought a small savings and loan nine years ago, the OTS became responsible for supervising AIG's parent company. Its duties expanded when European regulators in January 2007 conferred on the OTS the authority to supervise the company's overseas operations. A report by the U.S. Government Accountability Office last year said the OTS lacked the needed expertise.

Simply put, the job of the OTS was to make sure AIG did not take on too much risk and to assess the overall risk environment for the company and other global financial companies it oversaw.

But records show that, for several years before the bailout, numerous problems had surfaced with AIG's derivatives business, among them major accounting errors. More recently, a 2007 dispute with trading partner Goldman Sachs (GS, news, msgs) touched off a series of reviews and disclosures questioning the value of AIG's swaps.

Despite such signals, the OTS never took formal enforcement action. Lee said his office periodically raised concerns with AIG managers but wasn't worried about whether the swaps could put the company in a liquidity bind. "The risk of collateral calls was fairly low," he said.

It wasn't until March, after AIG once again disclosed significant valuation problems, that Lee sent a letter to the company asking for a "corrective action plan" in 30 days.

But Lee left his post in April to become a regional director in Dallas. His unit inside the OTS, formed specifically to take on global entities such as AIG, was quietly disbanded. AIG missed its deadline for a corrective plan, and the one it later submitted couldn't stop the company's decline.

Born in the savings-and-loan scandal

The OTS already has been targeted by critics who say its inaction, along with that of other regulators, contributed to the failures of Washington Mutual (WAMUQ, news, msgs) and IndyMac (IDMCQ, news, msgs), both federal banks. Earlier this year, Treasury Secretary Henry Paulson proposed abolishing the agency, with a $250 million budget and 1,000 employees, as part of a broad overhaul of financial oversight. Democrats in Congress have said reforming financial regulation will be a priority next year.

An earlier financial crisis gave birth to the OTS.

Savings and loans, or thrifts, used to be supervised by the Federal Home Loan Bank Board. But after the industry imploded in a late 1980s scandal -- and the quality of supervision was found to be wanting -- Congress terminated the board and replaced it with a new agency, the OTS.

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The office supervises a range of commercial and financial companies that own savings and loans, part of a patchwork of oversight that includes the Federal Deposit Insurance Corp., Federal Reserve and Office of the Comptroller of Currency, which also oversee national banks. Besides AIG, other companies with thrifts under the OTS include General Motors (GM, news, msgs), General Electric (GE, news, msgs) and some parts of the investment banks Merrill Lynch (MER, news, msgs), Lehman Bros. (LEHMQ, news, msgs) and Morgan Stanley (MS, news, msgs).

As the economy purred through the 1990s, few outsiders paid attention to OTS regulatory work. But within the financial-services industry, the agency stood as the preferred supervisor.

Continued: 1999 law sparked 'stampede'

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