AP IMPACT: They Warned Us, but US Eased Loan Rules

"It is not our role to be the regulator for the third-party lenders," wrote Ruthann Melbourne, chief risk officer of IndyMac Bank.

California-based IndyMac also criticized regulators for not recognizing the track record of interest-only loans and option ARMs, which accounted for 70 percent of IndyMac's 2005 mortgage portfolio. This summer, the government seized IndyMac and will pay an estimated $9 billion to ensure customers don't lose their deposits.

Last week, Downey Savings joined the growing list of failed banks. The problem: About 52 percent of its mortgage portfolio was tied up in risky option ARMs, which in 2006 Downey insisted were safe — maybe even safer than traditional 30-year mortgages.

"To conclude that 'nontraditional' equates to higher risk does not appropriately balance risk and compensating factors of these products," said Lillian Gavin, the bank's chief credit officer.

At least some regulators didn't buy it. The comptroller of the currency, John C. Dugan, was among the first to sound the alarm in mid-2005. Speaking to a consumer advocacy group, Dugan painted a troublesome picture of option-ARM lending. Many buyers, particularly those with bad credit, would soon be unable to afford their payments, he said. And if housing prices declined, homeowners wouldn't even be able to sell their way out of the mess.

It sounded simple, but "people kind of looked at us regulators as old-fashioned," said Brown, the agency's former deputy comptroller.

Diane Casey-Landry, of the American Bankers Association, said the industry feared a two-tiered system in which banks had to follow rules that mortgage brokers did not. She said opposition was based on the banks' best information.

"You're looking at a decline in real estate values that was never contemplated," she said.

Some saw problems coming. Community groups and even some in the mortgage business, like Welch, warned regulators not to ease their rules.

"We expect to see a huge increase in defaults, delinquencies and foreclosures as a result of the over selling of these products," Stein, the associate director of the California Reinvestment Coalition, wrote to regulators in 2006. The group advocates on housing and banking issues for low-income and minority residents.