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Fair value accounting and the subprime mortgage crisis

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Title: Fair value accounting and the subprime mortgage crisis  
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Subject: Subprime mortgage crisis, Financial accounting, Mark-to-market accounting
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Fair value accounting and the subprime mortgage crisis

The role of fair value accounting in the subprime mortgage crisis of 2008 is controversial. Fair value accounting was issued as US accounting standard FAS 157 in 2006. This required that tradable assets such as mortgage securities be valued according to their current market value rather than their historic cost or some future expected value. When the market for such securities became volatile and collapsed, the resulting loss of value had a major financial effect upon the institutions holding them even if they had no immediate plans to sell them.[1]

Contents

  • Fair value accounting 1
    • Definition of fair value accounting 1.1
    • How Fair-Value Accounting Came into Being 1.2
    • The Role Fair-Value Accounting Played in the Subprime mortgage crisis 1.3
    • Looking Forward: the Potential of Double-Presentation 1.4
  • References 2

Fair value accounting

Definition of fair value accounting

Fair-value accounting or Mark-to-Market is defined by SFAS 157 [2] as "a price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date". The definition is accompanied by a framework which categorize different types of assets and liabilities into 3 levels, and their measurement varied accordingly. The hierarchy of fair value is:
(1) Assets or liabilities whose values could be observed on an active market of identical assets or liabilities
(2) Assets or liabilities whose value could be quoted from an inactive market, or based on internal-developed models, with input data from observable markets of similar items.
(3) Financial assets and liabilities whose values couldn't be quoted from an observable market but instead based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement.

How Fair-Value Accounting Came into Being

1. Lessons from 1929 Stock Crash Under historical cost accounting, profits came to be calculated as the difference between the income accrued and costs incurred, according to revenue recognition and matching principal. This traditional measure of the profits did not prove adequate to value derivatives. In some cases, historical cost accounting didn't apply because there was little trading cost, (e.g. an interest-rate swap contract). And in other cases, because of the existence of fairly liquid markets and the wide use of valuation methodologies in financial markets to set asset prices, the relevance of historical cost accounting is largely undermined. In order to improve information transparency, and to better provide better inform investors about the interest and credit risks reflected, FASB began take steps to extend the application of the fair value principle to an ever greater range of assets and liabilities.

2.The Expanding Use of Derivatives In the 1980s, derivatives underwent significant development as they came to be used to hedge against interest and exchange rate risks. Additionally, derivatives started to be used by credit institutions as a new source of business. The large-scale use of derivatives by large and medium-sized corporations, together with the ever growing importance of capital markets, has led to major changes in the traditional practices used to prepare financial statements.

US Savings and Loan Crisis and Fair-Value Accounting
In the late 1980s and early 1990s, the Savings and Loan Crisis precipitated a collapse of the U.S. thrift industry. Investors demanded increased transparency, and historical cost accounting was blamed for creating rooms for banks to underestimate their losses. In 1991, the Government Accounting Office (GAO) issued a report that urged immediate adoption for both GAAP and regulatory reporting of mark-to-market accounting for all debt securities. It also suggested that a study be undertaken of the potential merits of a comprehensive market-value-based reporting system for banks.[3]
As fair value was increasingly viewed as an important tool for valuation, a clear guidance was needed for better application. In 2006, FASB issued FAS 157, which provided a uniform definition of “fair value” and guidance for application.

The Role Fair-Value Accounting Played in the Subprime mortgage crisis

One of the causes:
Brian S. Wesbury, Chief Economist, and Robert Stein, Senior Economist at First Trust Advisors in their “Economic Commentary” claimed that “It is true that the root of this crisis is bad mortgage loans, but probably 70% of the real crisis that we face today is caused by mark-to-market accounting in an illiquid market

Critics have blamed fair-value accounting for the subprime crisis, pointing out that fair-value accounting created difficulties measuring the value of subprime positions. They claim that fair-value accounting contributed to excessive leverage used by banks during boom period, and led to a downward spiral during bust period, forcing banks to value assets at “fire-sale” prices, creating a much lower than necessary valuation of subprime assets, which caused contagion and engendered the tightened lending.

Just a messenger:

“Fair value accounting…is a fundamental mechanism to provide investors with important transparency…. The roots of today’s crisis have many causes, but fair value accounting is not one of them.”
--Scott Evans, Executive Vice President, Asset Management at TIAA-CREF at October 2008 SEC roundtable on mark-to-market accounting (pg. 17)

Proponents argue that fair value accounting provides a clear measurement of the underlying value of assets. They state that the subprime crisis was not caused by accounting, but by bad operating of firms, investors and sometimes by fraud. It is unfair to blame the fair value accounting that is merely a reflection of the actual problem.

“Death spiral”, contagion and systemic risk
Banks are required to maintain “adequate capital” to comply with regulatory requirements. The capital ratio is the percentage of bank’s capital to its risk-weighted assets. Weights are defined by Basel Accords. Adequately capitalized banks are required to have a no lower than 4% Tier 1 capital ratio and a no lower than 8% total capital ratio. At the beginning of the crisis, the values of mortgage-backed assets started to fall, and firms holding mortgage-backed assets had to write those assets down to market value, the bank’s regulatory capital went down. Under certain loan covenants and regulatory capital requirements, banks were forced to sell mortgage-backed assets for cash to reduce “risk adjusted assets”. Some firms were also selling because of a fear that the prices will decline further. The fire sale created an excessive supply which further drove down the market price of mortgage-backed assets and the regulatory capital of banks continued to decline. This phenomenon is referred to as the “death spiral”.

Moreover, death spiral can lead to “financial contagion”. If fire-sale prices from a distressed bank become relevant marks for other banks, mark-to-market accounting can cause write-downs and regulatory capital problems for otherwise sound banks (Cifuentes, Ferrucci, and Shin, 2005; Allen and Carletti, 2008; Heaton, Lucas, and McDonald, 2009).[4] This is considered to be systemic risk in the banking industry.

Looking Forward: the Potential of Double-Presentation

To strike the balance between reliability and relevance, some scholars propose a double-disclosure—fair-value measurement backed up by historical cost figures: "The best way to ensure that regulators, investors, and the market at large have a full understanding of banks’ true financial conditions is to include changes in the value of financial instruments over time in financial statements, along with historical cost figures."[5]
In fact, FASB is not planning to abandon historical cost accounting for financial instruments held for collection or payment of contractual cash flows, because it provides useful information about the potential cash flows associated with these financial instruments. Indeed, the difference between amortized cost and fair value captures the expected impact of current economic conditions on existing financial instruments. FASB is recommending for financial instruments held for collection or payment of contractual cash flows that amortized cost and fair value information be given equal prominence on the financial statements and, thus, that both measures be made available for these financial instruments in public releases of financial reporting information. This dual presentation in financial statements — which some investors have asked for—would ensure that both relevant measures are given adequate attention by banks and their auditors.[6]

References

  1. ^ MR Young, PBW Miller (May 2008), "The role of fair value accounting in the subprime mortgage meltdown", Journal of Accountancy: 34–38 
  2. ^ http://www.fasb.org/summary/stsum157.shtml
  3. ^ Financial Reporting and Financial Crises: The case for measuring financial instruments at fair value in the financial statements, Thomas J. Linsmeier, Accounting Horizons, Vol.25, No.2 2011 pp. 409-417,http://www.fasb.org/facts/factstjl.shtml
  4. ^ Did fair-value accounting contribute to the financial crisis? Christian Laux and Christian Leuz, Journal of Economic Perspectives, Vol 24, No.1, Winter 2010, P93-118
  5. ^ Financial Reporting and Financial Crises: The case for measuring financial instruments at fair value in the financial statements, Thomas J. Linsmeier, Accounting Horizons, Vol.25, No.2 2011 pp. 409-417,http://www.fasb.org/facts/factstjl.shtml
  6. ^ Financial Reporting and Financial Crises: The case for measuring financial instruments at fair value in the financial statements, Thomas J. Linsmeier, Accounting Horizons, Vol.25, No.2 2011 pp. 409-417,http://www.fasb.org/facts/factstjl.shtml
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