The Clinton/Gore administration, however, was immensely fortunate in its timing. It inherited, due to the extraordinary regulatory scouring of the senior officers leading the financial control frauds that occurred under the first President Bush, the cleanest financial industry in history. Indeed, there was no historical parallel. More criminal prosecutions, removals and prohibitions, and civil suits were brought against elite financial leaders under the first President Bush than at any time in our history -- and there is no era that comes close. I believe that more senior financial officers and their co-conspirators were subject to such governmental actions under the first President Bush than in all other years from 1950 to the present -- combined. The data are not available to allow me to be definitive in this claim, but I believe I'm correct.
I'm making such a bold claim, despite the lack of definitive data, because I believe it is one of the critical dynamics that explains much of the purported "Great Moderation" and the timing of the current crisis. It takes time, in this case a full decade, for accounting control fraud to become endemic from a starting position of extraordinary success in removing the worst elements of the profession. It is no surprise that the strongest roots of the crisis, therefore, come from the virtually unregulated sectors of finance -- mortgage bankers such as Ameriquest and its ilk, loan brokers, investment banking firms, and bank affiliates, and suborned professionals. This in turn produced the Gresham's dynamic that spread the fraudulent lending practices throughout the more regulated realms of finance.
"Over the last several years, the subprime market has created a race to the bottom in which unethical actors have been handsomely rewarded for their misdeeds and ethical actors have lost market share". The market incentives rewarded irresponsible lending and made it more difficult for responsible lenders to compete" Miller, T. J. (August 14, 2007). Iowa AG.
As the Gresham's dynamic kicks in the rate of growth in the frauds increases dramatically. The accounting control fraud "recipe" makes the frauds the ideal means of hyper-inflating a financial bubble. The saying in the trade is that "a rolling loan gathers no loss." As the bubble hyper-inflates the lenders are able to (improperly) defer loss recognition for years by simply refinancing bad loans. This makes the timing of OMB's release of the Circular in 2003 all the more troubling. The massive expansion in the three fraud epidemics that drove the crisis occurred from 2003-2006. Liar's loans expanded by over 500% from 2003-2006 to roughly 40% of all home mortgage loans originated in 2006. They were the "marginal" loans that hyper-inflated the bubble even as conventional lending declined materially. Similarly, surveys of appraisers showed that between 2003 and 2006 the percentage of appraisers who reported that they had personally been subjected to efforts by lenders to extort them to inflate appraised values rose from 55 to 90 percent. These twin epidemics of fraudulent loan origination required an epidemic of fraudulent reps and warranties to sell the loans to the secondary market. This brings to mind two other words that are not contained in the Primer: "urgent" and "emergency." One of the most vital concepts in effective regulation -- the need to identify developing emergencies produced by criminogenic environments and react urgently by reregulation to dramatically reduce that criminogenic environment do not exist in the Primer.
At the moment (2003) the fraud epidemics that drove the most recent financial crisis were becoming pandemic OMB acted to make the financial industry even more criminogenic. The second President Bush destroyed his father's legacy of successful financial regulation, enforcement, and prosecution. It ignored also the Enron-era epidemic of accounting control fraud.
It would have been a travesty for the Obama administration to continue the Bush administration's unholy war on regulation had there been no epidemics of accounting control fraud driving the U.S. into a Great Recession that cost over 10 million jobs and $21 trillion in lost production.
Obama has kept in force Executive Order 12866 -- an order that is hostile to regulation and should have been discredited by multiple financial crises resulting from the fraud epidemics caused by the three "de's." The Circular emphasizes the Executive Order's absurd presumption that modern financial "markets" exist and could function well without the rule of law that can only be established through vigorous regulation, supervision, and enforcement. The Executive Order treats regulation and markets as dichotomous rather than as essential complements.
"Executive Order 12866 states that 'Federal agencies should promulgate only such regulations as are required by law, are necessary to interpret the law, or are made necessary by compelling need, such as material failures of private markets to protect or improve the health and safety of the public, the environment, or the well being of the American people " .'"
The Primer thinks it is displaying optimal decision-making in passages such as this:
"Consistent with Executive Order 13563, section 4, an agency might consider flexible approaches that maintain freedom of choice. If, for example, an agency is considering banning the sale of a potentially unsafe product, it might consider instead requiring disclosure of health risks to the public.
Once an agency identifies the least burdensome tool for achieving its regulatory objective"."
This approach guarantees recurrent, catastrophic regulatory failure. A firm produces an unsafe product for one of three reasons. First, incompetence, which often leads to the firm not knowing that its design or production are defective -- which means that they are not able to provide a warning. Second, the firm gains a competitive advantage over its competitors with integrity who do not produce unsafe products for sale to the public. Third, the firm is anti-purchaser control fraud that deliberately gains a competitive advantage over its competitors by misleading the consumers about quality.
In the case of incompetence the discovery by the regulator of the hidden defect is vital as is banning the product and sanctioning the manufacturer as a means of providing specific and general deterrence. In the case of lack of integrity and control fraud it is essential that the perverse advantages of producing and selling unsafe products be stopped by the regulators so that a Gresham's dynamic is prevented. What does not work is trying to educate hundreds of millions of potential consumers about the reasons why the product is unsafe and the special steps that the consumer should take to reduce the risk of being maimed or killed by the product. Note that many unsafe products -- think GM"s ignition system -- endanger not only the purchaser but anyone driving the car and anyone driving at the same time and place when the inherently unsafe ignition system suddenly turned off the car's electrical system. Without the electrical system the car was turned into an unguided ground missile that endangered the safety of everyone on the roads.
There is an immense literature on why information measures fail to protect consumers and investors. The validity of that literature was (again) proven in the most recent financial crisis. OMB remains immune to science that falsifies its theoclassical dogmas.
"Informational Measures. If intervention is contemplated to address a market failure that arises from inadequate or asymmetric information or poor information processing, informational remedies will often be preferred."
OMB's failure to understand the Gresham's dynamic and the fact that consumers and investors typically do not optimize their purchases also leads it to demand that agencies use a quantification process in performing benefit-cost analysis that must inherently produce unreliable data that will typically systematically understate the benefits of the rule and overstate its costs.
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