In 2005 the comptroller of the currency, John C. Dugan, was among the first to sound the alarm that interest only and negative amortization loans were a looming threat to the stability of the mortgage banking system. 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.

Flexible payment loans, called Option ARMs are adjustable rate mortgages with several flexible payment options. Generally they allow a homeowner to make a full payment according to a standard payoff schedule, or to pay only the interest with no payment towards the loans principal, or even a lesser “negative amortization” amount which would allow some of the interest owed to add to the original principal. These loans existed for only one reason, to create a lower initial payment structure to allow a buyer to acquire a property that she couldn’t afford. Unfortunately, the low payments always had a sunset provision, in the case of many homeowners, a true drop dead provision. At the end of two years or perhaps three, the loans would reset to the higher full payoff paced payment which the borrower generally couldn’t afford. The only possible salvation to a homeowner in these time bomb loans was to refinance or sell. In a down market, with tight credit, these homeowners are facing a perfect storm with no way out. The risk was never a mystery, it was just ignored.

Warnings came from all sides of the mortgage market.

We expect to see a huge increase in defaults, delinquencies and foreclosures as a result of the over selling of these products,” Kevin Stein, 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.

But bankers, afraid of having their opportunities limited fought the regulations. “To conclude that ‘nontraditional’ equates to higher risk does not appropriately balance risk and compensating factors of these products,” said Lilian Gavin, the Chief Investment Officer of Downey Savings which carried over 50% of its loan portfolio in these products. Downey insisted these loans were safe — maybe even safer than traditional 30-year mortgages.

In 2005, faced with ominous signs the housing market was in jeopardy, bank regulators proposed new guidelines for banks writing risky loans. Today, in the midst of the worst housing recession in a generation, the proposal reads like a list of what-ifs:

_Regulators told bankers exotic mortgages were often inappropriate for buyers with bad credit.

_Banks would have been required to increase efforts to verify that buyers actually had jobs and could afford houses.

_Regulators proposed a cap on risky mortgages so a string of defaults wouldn’t be crippling.

_Banks that bundled and sold mortgages were told to be sure investors knew exactly what they were buying.

_Regulators urged banks to help buyers make responsible decisions and clearly advise them that interest rates might skyrocket and huge payments might be due sooner than expected.

Those proposals all were stripped from the final rules. None required congressional approval or the president’s signature.

“In hindsight, it was spot on,” said Jeffrey Brown, a former top official at the Office of Comptroller of the Currency, one of the first agencies to raise concerns about risky lending.

Unfortunately for the rest of us, the regulators bent to the banks and the financial fallout has trashed everything.