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Are Federal Regulators To Blame For The Crash?

Here's a question that seems pretty timely: How much of the unsustainable sizes of the stock market and housing bubbles is due to regulatory incompetence or mistakes?

There may never be a definitive answer, especially because there are so many explanations for why the economy became so bubblicious, including the Federal Reserve's excessively low interest rates, tax law changes and garden-variety fraud.

But this week's news about Darrel Dochow may provide a partial answer. Dochow was the west coast regional director at the Treasury Department's Office of Thrift Supervision, which is tasked with the job of regulating savings banks and savings and loans. OTS's official mission is "to supervise" such companies "to maintain their safety and soundness."

The problem is that Dochow may not have done exactly that. In fact, he seems to have done the opposite.

Dochow was removed from his job in December after an internal investigation found that he had allowed IndyMac Bank to backdate a transaction, yielding a falsified report that let it be rated as "well capitalized." As we now know, IndyMac subsequently collapsed, making it the second-largest failure to date.

Treasury's inspector general, Eric Thorson, ominously noted in a December letter to members of Congress that IndyMac was not the only example of legerdemain: Dochow's agency let other banks cook the books too.

The Washington Post reported at the time: "It is the second time Dochow has been removed from a position as a senior thrift regulator. He was demoted in the early 1990s after federal investigators found that he had delayed and impeded proper regulation of Charles Keating's failed Lincoln Savings and Loan." That S&L was at the heart of the Keating Five scandal, which led to prison time for Keating and cost taxpayers billions. (Here's a 1990 article with some details about Dochow's role.)

In an August 2007 letter from Dochow to CEOs of banks he regulated, Dochow stressed his intention to "continuing the close working relationship that I have enjoyed with many of you" and said there would be no "significant changed in this office's general philosophy."

Now Dochow has been allowed to retire apparently with his full pension based on a $230,000 annual salary -- as opposed to being fired for cause -- according to an ABC News report this week. Meanwhile, taxpayers are on the hook for even more with IndyMac's failure than they were for the failure of Lincoln Savings and Loan.

As a side note, federal law says: "Whoever knowingly makes any false statement or report, or willfully overvalues any land, property or security, for the purpose of influencing in any way the action of the... Office of Thrift Supervision... shall be fined not more than $1,000,000 or imprisoned not more than 30 years, or both."

Dochow isn't the only recent example of regulatory failure.

There's also the failure of the Securities and Exchange Commission to stop Bernie Madoff, even though Harry Markopolos had tried repeatedly to direct the agency's attention to Madoff's alleged Ponzi scheme. Peter Schiff, president of Euro Pacific Capital, also raised concerns about Madoff.

It probably didn't hurt that his niece Shana Madoff (a former compliance officer at Madoff Investment Securities) married Eric Swanson, a former assistant director at the SEC's Office of Compliance, Inspections and Examination. Another bit of trivia: President Obama's SEC Chairman Mary Schapiro was running the Financial Industry Regulatory Authority when it investigated Madoff -- and failed to stop him.

And then there's the Office of Federal Housing Enterprise Oversight, which was supposed to ensure "the safety and soundness" of Fannie Mae and Freddie Mac. OFHEO had nearly 300 employees, all devoted to this task.

But OFHEO was slow to recognize problems, and when it did, it had limited powers. The result? Fannie and Freddie already have received a $400 billion bailout in the form of stock and debt guarantees; Fannie lost $59 billion last year and has said it needs $35 billion more in bailout funds.

Let's not forget about American International Group, which has already put $170 billion in bailout funds at risk and lost $62 billion in the last three months of 2008. At a Senate Banking committee hearing on Thursday, Scott Polakoff, acting director of the Office of Thrift Supervision, admitted a "failure to recognize in time the extent of the liquidity risk to AIG" and said his agency "focused too narrowly" on the wrong areas.

We're likely to hear a lot in the next few months about market failures by politicians pushing new laws. But regulatory failures can be just -- or even more -- destructive.