Fundamental Issues Lying behind the Sub-prime Mortgage Crisis (4): The Sin of Greed

This vedio fully expressed common people's anger about Wall Street's crazily risk-taking behaviors driven by their  lust for money.Human beings are self-interested and it is the maximization of individual interest that privides the innitial momentum of the capital market. However, we should also notice that it becomes a different story when a group of smart people get together in Wall Street and start to exhaust every possible way to maximize profit.  Who would deny that all the financial crisis originated from the Biblical sin of Greed?  Moreover, should fair-value accounting take the blame of disclosing twisted financial accounts when the accounts' value had been twisted by the Wall Street genius in the first place?

Fundamental Issues Lying behind the Sub-prime Mortgage Crisis (3): Financial-Accounting

Fair-value accounting seemes to come into play in the falling apart of U.S. financing market in the subprime mortgage crisis when investment banks were forced to write down values of CDOs, MBS and morgages sitting on their balance sheets. People argue that if the investment banks had disclosed asset values with historical cost accounting, there wouldn't have been a sharp down-turn of their asset value.
However, according to formal analysis, the fundamental problems lie in the capital supply and regulation. It seems that accounting standards generally turn into the target of criticisms after financial crisis, and this time fair-value accounting took the most blames. In our opinion, it is the improper and excessive risk assuming that brought down the operation of investment banks, and fair-value accounting just faithfully reflected the downturn value on banks' financial statements. To some extense, fair-value accounting facilitated the disclosure of the investment banks' overvaluation to broader investors and prevented the bubble from further growing. Had there been no fair-value accounting, but historical cost accounting instead, the information of increasing mortgage default might be still released through other media and reflected in the falling prices capital market. Therefore, fair-value accounting might have changed the timing of bursting, but it couldn't change other fundamental  causations of the bubble. In another word, to swich back to historical cost or other accounting measurement wouldn't prevent the submortgage crisis from happening.

A comment by Bob Pozen of Harvard Business School made it clear that fair-value accounting isn't the major causation of the financial crisis.

Fundamental Issues Lying behind the Sub-prime Mortgage Crisis (2): Over-leverage

To follow up last discussion about capital supply, when faced with enormous "cheap credits", investment banks were tempted to borrow more. Meanwhile, the change of SEC leverage rule also facilitated banks to land on a higher leverage ration. As a matter of fact, during the past SEC had limited companies debt-to-net capital ratio to 12-to-1, while in 2004 SEC gave 5 major investment banks (3 failed in the housing crisis)  an unbelievable exemption of 30-to-1 or even 40-to-1!
When market is functioning, the high leverage brought huge profit to investment banks, thus also making them greeder and driving them to leverage more. So it's not surprising that when the housing bubble burst, the investment banks had difficulties in refinancing their short-term debt and were forced to bankruptcy.

One lesson from the housing crisis is that regulators should come up with more stringent leverage requirements as a safeguard against credit crisis. In 2007,FDIC did caution against the more flexible risk management standards of the Basel 2. According to Chair Shelia Bair : "There are strong reasons for believing that banks left to their own devices would maintain less capital—not more—than would be prudent...Without proper capital regulation, banks can operate in the marketplace with little or no capital. And governments and deposit insurers end up holding the bag, bearing much of the risk and cost of failure. History shows this problem is very real … as we saw with the U.S. banking and S & L crisis in the late 1980s and 1990s. The final bill for inadequate capital regulation can be very heavy. In short, regulators can't leave capital decisions totally to the banks. We wouldn't be doing our jobs or serving the public interest if we did."

Fundamental Issues Lying behind the Sub-prime Mortgage Crisis (1): Capital Oversupply

First, let’s look at the all sources capital supple prior to the housing bubble:

1.       After the .com bubble burst, Greenspan lowered the interest rate on treasury bonds to 1%, which means cheap loans to Wall Street investment banks.

2.       “Hot money” from Japan, China and Middle East, looking for investment opportunities.

3.       Institutional investors who turned away from the low-return treasury bonds.

However, the economy didn't have enough time to recover from formal recession and the slowed-down industrial development reduced investment opportunities for Wall Street Bankers.

With the huge amount of money on hand, investment banks are desperate for loaners. They lowered the threshold of getting house mortgages to such a crazy level that people could buy a house that they couldn’t afford. Therefore, large amount of future defaults on sub-prime mortgages became inevitable.

When people started to default on house mortgages, houses instead of cash inflow piled up and made CDOs’ value shrink significantly. Therefore, investment banks couldn’t sale enough CDOs to pay back their loans and went bankruptcy; financing market was frozen and thus came large-scaled financial crisis.

So we could see that everything started from capital supply in the U.S. market. Had Fed established appropriate policies to control excessive external investment or applied more fiscal policy to redirect the funds from the capital market, the situation might look different now.

Another direct cause of the financial crisis is the over leverage of investment banks, which goes to another debate over whether we need more regulation to prevent credit crisis like this in future.

Crisis and behavior

 Today during the "Market Efficiency" debate, I cannot help thinking about an article I read about human behavior.
One of the assumption of the efficient market hypothesis is the "rationality" hypothesis.
But are people rational? There might be some of them. But rational people can sometimes use the bubble to profit from unsophisticated irrational investors.

Now comes to fair-value, there are all the "safeguards" and room for discretion in fair-value accounting, why people keep accusing fair value as to blame for the death spiral and contagion?

One reason maybe that people are not rational enough. They thought that the housing price would never go down. At the beginning, they did not fully understand fair-value standards, and they did not care, for they were making money.
Then the price went down, some of them were too scared of punishment from using discretion, they just set the price so low even if they were using tier2&3 inputs.

I quoted two paragraph from"The Behavioral Revolution By DAVID BROOKS"

Source:http://www.nytimes.com/2008/10/28/opinion/28brooks.html?pagewanted=printO

"Taleb believes that our brains evolved to suit a world much simpler than the one we now face. His writing is idiosyncratic, but he does touch on many of the perceptual biases that distort our thinking: our tendency to see data that confirm our prejudices more vividly than data that contradict them; our tendency to overvalue recent events when anticipating future possibilities; our tendency to spin concurring facts into a single causal narrative; our tendency to applaud our own supposed skill in circumstances when we’ve actually benefited from dumb luck.

And looking at the financial crisis, it is easy to see dozens of errors of perception. Traders misperceived the possibility of rare events. They got caught in social contagions and reinforced each other’s risk assessments. They failed to perceive how tightly linked global networks can transform small events into big disasters. "

Joint Project of the IASB and FASB on Fair Value Measurement

Background Information
The FASB issued Statement No. 157, Fair Value Measurements, in 2006, and its guidance has been effective since November 2007. In May 2009, the IASB issued an Exposure Draft on fair value measurement in which it used Topic 820 of the FASB Accounting Standards Codification^TM as a starting point. At the October 2009 joint Board meeting, the FASB and the IASB agreed to develop common fair value measurement guidance.

On May 12, 2011, the FASB completed this project with the issuance of Accounting Standards Update No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requiremetns in U.S. GAAP and IFRSs.

On May 12, 2011, the IASB completed this project with the issuance of IFRS 13, Fair Value Measurement. IFRS will be effective on January 1, 2013. 

Project milestones(IFRS)

Resources:

http://www.ifrs.org/Current+Projects/IASB+Projects/Fair+Value+Measurement/Fair+Value+Measurement.htm

http://www.fasb.org/cs/ContentServer?c=FASBContent_C&pagename=FASB%2FFASBContent_C%2FProjectUpdatePage&cid=1176156576143

IFRS 13 Short Explanation:

Source:http://www.youtube.com/watch?v=3fWTPqO80k0

Sunder's view on fair value

While reading, I found something extremely amusing.

I quoted these two paragraphs from
Shyam Sunder. 2009. “IFRS and the Accounting Consensus,” Accounting Horizons,Vol 23, No. 1 (March), pp. 101-111.

"Market valuation is a principle, as is historical cost valuation. In contrast, fairness is an ex post judgment about a particular instance of valuation in the eyes of preparers and users. Alternatively, it could be thought of as their ex ante judgment about the outcomes expected from a given method of valuation. How can a standard specify the numbers arrived at by the application of a particular method to be “fair” by definition?

Financial Accounting Standard 157 (FASB 2006) specified three unrelated valuation methods (mark-to-market, mark-to-model, and mark-to-judgment) to be used in different circumstances and declared their combination to be “fair.” Note that the last of these three options allows firms to value assets as they deem fit when market values or model parameters cannot be objectively estimated. Warren Buffet pointed out that the third level of “fair” risks becoming mark-to-myth. In mid-October 2008, in response to political pressures, the IASB (2008) proposed to allow special dispensation for application of fair values to financial instruments. In what sense can this proposal be called a principle, and not the beginning of the slide down the proverbial slippery slope of clarifications and guidance that land the general principles in a morass of complex rules under pressure from money and power?"

Before I got a closer view at FAS 157, I thought that fair value means market value, that is the price which other people are willing to pay.

Now I know that FAS 157 provides three levels of inputs. But for the mark-to-model and mark-to-judgment, how can you verify the reliability of those figures? Aren't they just numbers based on estimates?

Just like a man predicts: there is 50% chance that tomorrow will rain. We cannot say he is wrong no matter tomorrow rains or not. We also cannot say the estimates provided by managements are WRONG, for things are changing, they might be right at the time of estimation, and they might also just make up those numbers. Who knows.

As Fama said, if people can know the fundamental value of stock, they will all be rich men. We always talk about fundamental value or true value, but we really do not know what fundamental value is.