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.

When the Crisis became Global...

The Greek Crisis Explained, Sep 2010

To NOMINT's eyes, Greece is a spoiled young girl and the dept,
once a lovely pet sheep, appears now to be a humongous creepy monsterabout to devour her.

source:http://www.youtube.com/watch?v=--TABdLsWSU&feature=related

Debt Contagion and the Global Economic Collapse, Jun 2011

source:http://www.corbettreport.com/sunday-update-20110626/

Greek's economy is over leveraged by debt. Earlier last year, corruption and book cooking got Greek into big financial scandal, and the following credit down-grading directly caused her this nation-wide financial crisis. Is fair-value accounting/accounting in general one of the drivers that push Greek off the brink of crisis? Maybe or maybe not. 

Some people are questioning that there are other countries with even more bureaucracy and corruption, yet didn't step into national wide financial crisis, why these European countries? The rationality that they are just victims in a international political contest. America faced the sub-prime mortgage crisis starting from 2007, which brought the world's most powerful economy into a big recession. As there came up more and more doubt over u.s dollars as the international currency, and the proposal kept gaining influence that u.s. dollars being replaced by another global currency, say euros,America was forced to defend the superior position of dollars, and down-grading EU member countries was just one of the weapons America used.But in my opinion, fair value did played a role in the Greek crisis. Compared to historical cost accounting, fair value accounting provides information that are more relevant and updated. However, the reliability of the information has to be compromised since the measurement are more forward-looking, which might opened the door for earning management/manipulation. Besides, fair-value accounting also increased volatility to financial statements.The value of assets sitting on Greek's balance sheet was forced to shrink dramatically after the credit down-grading,thus worsening the situation. Therefore, fair-value might not be the initial cause of Greek crisis, but it could be the last straw, just like its role in the 2008 subprime mortgage crisis.

“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). This is considered to be systemic risk in the banking industry.

Reading Summary: Linsmeier 2011

Fair value measurement:

US Savings and Loan Crisis and Fair-Value Accounting

In the late 1980s and early 1990s, Savings and Loan Crisis observed a collapse of the U.S. thrift industry. Investors demanded for increased transparency, historical cost accounting was blamed for creating rooms for banks to underestimate their losses.

In 1991, the Government Accounting Office (GAO) issued a report which 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.

As fair value was increasingly viewed as an important tool for valuation, a clear guidance is needed for better application. In 2006, FASB issued FAS 157, which provided a uniform definition of “fair value” and guidance for application.


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."

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.


Reference: 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

Our Personal Opinion to Add on the Double-Presentation:

It is good to have both sides of the story, one more relevent, one more reliable. Besides, the reconciled difference between the two measurements could serve as a early alarming of potential accounting frauds or request for necessary justifications and adjustments.It would significantly improve information transparency in financial accounting.
However, it might also cause confusion among unsophisticated investors and extra disclosing cost to issuers. Therefore,the balance between the cost and benefit should be carefully examined.
To add on the double-presentation proposal,I think: (1) it would be better to voluntary rather than mandatory if the proposal does get pass by SEC, because it would cause extra burden on both the management who prepare the financial filings and external auditors who reconcile and verify both. According to lemon-market theory, companies with higher profile and more competitiveness would be willing to disclose both sides of story if that could better distinguish themselves with "lemons". (2) A reconsiliation should be provided and explanation should be provided accordingly if there is material discrapency between the two measurements, so that investors wouldn't be confused of the differences and be able to make more rational decisions.

Reading summary: Laux and Leuz 2010

Did fair-value accounting contribute to the financial crisis?

Useful information extracted from the paper:

Critics argue that fair-value accounting exacerbated the severity of the 2008 financial crisis. The main allegations are that fair value contributes to excessive leverage in boom periods and leads to excessive write-downs in busts. The write downs set off a downward spiral, which in turn leads to contagion.

However, based on Laux and Leuz’s research and analysis, there is little reason to believe that fair-value accounting contributed to U.S. banks’ problems in the financial crisis in a major way.

1.       Fair value play only a limited role for banks’ income statements and regulatory capital ratios except for a few banks with large trading positions. For these banks, investors would have worried about exposures to sub-prime mortgages and made their own judgments even in absence of fair-value accounting.

l  “Trading assets” are reported at their fair value, and fair value changes are recognized in Income Statement. (33% for large investment banks and 12% for large bank holding companies, but very small fraction smaller bank holding companies)

l  In 2007 and 2008 only a negligible fraction of nontrading assets were reported under fair value option provided by FAS 159.

l  For large bank holding companies, about 36 percent of assets are reported at or close to fair value, another 50% are subject to fair value disclosure. For investment banks, the fraction of assets reported at fair value turn to be higher. Among assets recorded at fair value, level 2 inputs comprise the largest category. Level 1 and level 3 play a much smaller role.

l  For investment banks, outside investors would have been concerned about fair value even if the assets had been recorded at historical cost. Banks seemed to overstate the value of their assets. Increasing haircuts in a downturn are sufficient to produce procyclical leverage.

l  For bank holding companies, income statement and regulatory capital are already shielded from many fair-value changes. The biggest position, the held-for-investment loan is not subject to fair-value accounting. For the second biggest category, available for sale, FV changes are in OCI. Temporary changes will not affect regulatory capital. By selling and repurchasing securities, banks can get around historical cost accounting restriction to writing up assets if banks want to increase its leverage.

2.       Various safeguards exist in extant rules, and banks have offered substantial discretion to avoid marking to distorted market prices.

l  FAS 157 explicitly states that prices from a forced liquidation or distress sale should not be used in determining fair value.

l  Banks choose how to classify their securities at the outset (under FAS 115).

l  When markets become inactive and transaction prices are no longer available, banks are not forced to use dealer quotes that are distorted by illiquidity. FAS 157 allows banks to use valuation models to derive fair values.

l  By the first quarter of 2009, for bank holding companies, level 1 inputs decreased from 34% to 19%, level 3 inputs increase from 9% to 13%. For investment banks, level 3 increase from 7 to 14 percent, level 1 decrease from 27 to 22 percent.

l  Mortgage-related assets are rarely Level 1 assets. At the beginning of the crisis, Level 2/3, and many moved to level 3 early in crisis.

3.       Little evidence suggests that prices were severely distorted due to fire sales of assets or that banks were forced to take excessive write-downs during the crisis.

l  Coval, Jurek and Stafford(2009), the repricing of credit risk appears consistent with the decline in the equity market, and increase in its volatility, and a better pricing of the risks embedded in structured product.

l  Longstaff and Myers(2009), bank equity prices and equity tranches from collateralized debt obligations were priced consistently between 2004 and 2009.

Conclusion: the claim that fair-value accounting exacerbated the crisis is largely unfounded.

It may be more appropriate to loosen regulatory capital constraints in a crisis than to modify the accounting standards, as the latter could hurt transparency and market discipline.

Reference: 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

SFAS 157, Fair value measurements

SFAS 157, Fair value measurements

The Statement of Financial Accounting Standards (SFAS) 157, known as ASC 820 in the FASB Codification, is the other controversial and interesting standard I choose to talk about. Issued by FASB in September 2006, SFAS 157 defines fair value and provides guidance for fair value measurement and disclosures.  This Statement is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. According to SFAS 157, fair value is “the 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 categorizes 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.

Critics have blamed SFAS 157 for the subprime crisis, pointing out that SFAS 157 created difficulties measuring the value of subprime positions. They claim that this standard forced financial institutions to value assets at “fire-sale” prices, creating a much lower than necessary valuation of subprime assets, which engendered the tighten lending. But 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 ridiculous to blame the fair value accounting that is merely a reflection of the actual problem.

The SEC is in support of the SFAS 157, concluding that SFAS 157 was not the cause of the financial institution failure and that this standard should not be suspended but could be improved. 

To get a better understanding of Statement No. 157, you can go to FASB website:

http://www.fasb.org/summary/stsum157.shtml or refer to Accounting Standard Codification Topic 820.

What are we talking about?

In this blog, we are mainly talking about Fair Value Accounting and its effects on the 2008 Financial Crisis.

There will be discussions, reading summaries, or anything interesting and relevant to the topic.

Since the content consists of our understanding and personal opinions on certain controversial topics, different ideas and elaborations are warmly welcome. Please feel free to comment on anything posted or correct any misrepresentation we made.

Thank you.