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Accounting and the Credit Crisis of 2007/2008

Part II: Why It All Went Wrong

On January 30, 2008 the anger and suspicion exploding from the credit crisis with its billions of dollars of investor and homeowner losses had reached the point that the Wall Street Journal reported that the Federal Bureau of Investigation was opening criminal inquiries into 14 companies as part of a broad investigation. At the same time, the Securities and Exchange Commission had begun investigations into sub-prime mortgage and securitization issues at various large financial companies such as Bear Stearns, New Century Financial, Morgan Stanley, and Goldman Sachs Group. As well, by January 2008 scores of lawsuits including shareholder class action, fiduciary, and malpractice suits had been filed against many financial companies. In March 2008 the spectacular collapse and emergency sale of 85-year old Bear Stearns to JP Morgan created a new financial shockwave around the world. This was finally followed by the monumental collapse of Lehman brothers in September 2008 that brought the world's financial markets to near a shut-down, with a real risk of economic depression. The credit crisis had clearly escalated to a dangerous magnitude, and now thousands of injured parties were trying to figure out what went wrong and were looking for someone to blame.

Here, we will examine the key events and the players in these events. Then we can begin to piece together what went wrong. The events involved the participation of all the following actors: The Federal Reserve Bank, banks as mortgage lenders, investment companies buying and securitizing loans, rating companies, the application of generally accepted accounting principles, and investors who wanted ample, easy, and safe profits.

The Federal Reserve Bank

In the United States, the Federal Reserve System (the “Fed”) is a central national bank that has the ability to control the money supply and change important interest rates. In response to an economic slowdown in 2001, the Fed greatly lowered interest rates over a period of about 2 years. However, these lower interest rates over-stimulated the economy, especially the housing market, which began to see record sales and price increases. Worried about inflation, the Fed then reversed monetary policy in 2004 and over a period of several years began to significantly raise interest rates, making loans more expensive and in particular making the payments higher on adjustable rate mortgages, which many home buyers had used to purchase their homes. Because of the continued rapid rise in rates, many buyers could no longer afford their home loan payments and eventually stopped paying.

The Transaction Process: Mortgage Lenders and Investment Companies

Step 1: Making Loans

When a bank or other lender loans money to a home buyer, the lender’s cash decreases and is replaced by a different asset, which is a long-term receivable (a note receivable) that is of equal value. Historically, a lender has had two choices at this point: 1. Keep the note and collect the principal and interest payments from the borrower over the term of the note, or 2. If the note is secured by a sufficiently high value property and the borrower is very credit-worthy, the note could be sold to federal government sponsored mortgage buying agencies (such as the Federal National Mortgage Association: “Fannie Mae”). Selling the note replaces the cash and usually records a profit for the lender bank. With the new cash, the lender can then continue making more loans and also satisfy the bank capital requirements imposed by government regulations.

During the early 2000s real estate values continued to increase, and lenders saw a great opportunity: There were many more, but less-qualified, homebuyers who were still eager to purchase homes and would pay higher interest rates and fees than on more secure loans. To accommodate these marginal buyers, lenders reduced their lending standards. By October 2007, a Senate joint economic committee estimated that almost a trillion dollars of outstanding lower-quality (“sub-prime”) loans had been made, many of these adjustable rate loans. In turn, all this loan money available to buyers increased home sales and pushed real estate prices even higher, making lenders believe that the loans were secured by more than enough property value, even if financially problematic buyers might have trouble making their loan payments.

Step 2: Transfer and Securitization

Because the sub-prime loans were of much lower quality, the lenders had a potential problem. The new notes receivable could not be sold to government sponsored agencies (although this later changed when the agencies received approval from Congress to purchase sub-prime loans, thereby making the eventual problem much worse). To find another source of mortgage buyers, the lenders did some creative financial thinking and utilized another alternative. The lenders sold the loans to large investment companies (such as Lehman Brothers, Merrill Lynch, etc.) who paid the banks cash for the loans or bank securities backed by the loans. In turn, the investment companies created other companies designed especially to purchase the loans from the investment companies. These special companies are called “structured investment vehicles” or “SIVs” and the process is often called “structured financing.”

However, when the SIVs acquired the notes or note-backed securities, they borrowed extremely heavily — in some cases, up to $30 of debt for every dollar invested in the notes by the SIV. The ultimate effect of this borrowing would be to greatly magnify the size, power, and speed of potential losses.

The SIVs kept the notes and “securitized” them. This means that the SIVs created securities that investors would pay for. Investors included many large companies that purchased billions of dollars of these securities at market value. The SIVs used the cash from the investors to pay the investment companies for the notes. Then, as long as the notes continued to receive the principle and interest payments from the borrowers, this cash could be passed along to the investors (with a little taken as profit for the SIVs and investment companies). Most often, the securities that the SIVs created were short-term notes payable called “asset backed commercial paper” (a common type is a “CDO” - collateralized debt obligation). In effect, when investors purchased this commercial paper, they were accepting the risks associated with the risky loans that were security for the commercial paper. In many cases, the investment companies and SIVs offered various kinds of explicit and implicit assurances to the investors. Basically, the events looked like this:

Balance sheet

Why All the Steps?

  1. The bank needs to sell the notes to obtain cash and remove the risky notes from its balance sheet. This makes the balance sheet look better and renews the cash balance. The bank also records a profit when the note is sold.
  2. The investment company knows how to create and sell securities to investors. Like the bank, the investment company wants to remove the low-quality notes from its balance sheet. Also the investment company records a profit from the SIV when the securities are sold to investors.
  3. SIVs are used because the investment company needs a business that it can control and at the same time that will purchase the notes and keep them off of the balance sheet of the investment company.

The Accounting Issues

Issue #1: The Entity Principle

One of the first basic accounting principles taught to students is the “entity principle”. This principle states that it is necessary to identify the particular organization or economic unit (the “entity”) for which the accounting is to be performed. If an entity cannot be identified, accounting becomes meaningless. (It becomes impossible to apply the accounting equation - see Part I.) Very detailed and complex accounting rules require that any business that creates another business must relinquish all effective control over the new business in order to recognize the two entities as separate; in other words, separate accounting equations for each economic unit. “Control” is not only direct control such as voting, but also indirect economic influence such as guarantees or implicit obligations to support the new company.

However, investment companies almost always exercise direct or indirect control over SIVs. So, on which set of books should the SIV transactions have been recorded? Should there be just one accounting equation for the combined activities? It was clear that those companies that had provided explicit guarantees to SIVs had direct influence, so many of these investment companies had to keep the notes on their own books and record all the investment losses on their own books. However, some large investment companies provided only implicit assurances, which were never fully clarified. Some of these large companies, to save their reputations, eventually agreed that the SIVs were not really separate companies and the companies then recorded the SIV transactions on their own books and absorbed the SIV losses.

Previously unrecorded and undisclosed obligations to repay the SIV investors suddenly appeared on the balance sheets of the investment companies. Because of the arcane complexity of the accounting rules, most investment company stockholders had no idea that this potential liability existed, or how it could happen. These surprise actions became the objects of numerous lawsuits.

Issue #2: Classification

Classification is an essential dimension in accounting (classification, valuation, and timing). When a transaction is recorded, all parts of the transaction must be correctly classified in the accounting equation by type of asset, liability, and owner’s equity item. With the creation of the SIVs, in some cases the misclassification went far beyond the need to correctly classify a particular item in the accounting equation - assets and liabilities were classified as part of the wrong business entity! (Because in many cases the SIV transactions should have been on the books of the investment companies all along.)

Issue #3: Valuation

Valuation is one of the most deeply divisive issues in accounting. Although numerous accounting valuation rules are in place, there remains widespread professional controversy concerning their efficacy and consequences. What the general public does not often appreciate is that value, whatever method is used, is subjective. Except for cash, an asset’s value is never exactly known until it is converted into cash (sold) or discarded (zero value). Some non-cash asset values can be more reliably determined than others, but the essential point remains.

Investors that purchased the complex financial assets without any gaurantees clearly owned them, and had the problem of determining the correct values to use for these assets on their balance sheets. In general, accounting has been evolving toward what is called current “fair value”. This sounds good, but often “fair value” can be difficult to determine.

For financial assets, complex accounting rules require management to decide the purpose of the investment (active trading, available for sale, or held to maturity). The type of the investment determines the type of accounting valuation method to apply and how the value and changes in value will be reported. For example, trading and available for sale financial assets are required to be valued at selling market prices, which are determined under a 3-tier system. However, in a short-term collapsing market, market values can change violently and unpredictably, and may briefly fall to such low levels as to make a company insolvent due to the extreme loss of asset value.

As well, keep in mind that these valuation changes result in “paper” gains and losses - the assets are not being sold - no cash is involved. However, fair value certainly does provide financial statement users with one significant benefit - a healthy appreciation that asset wealth can and does decrease (or increase) unpredictably, long before the assets are sold. As values declined, there was intense criticism of fair value accounting for financial assets (often called “mark to market”); however, it is interesting to note that there was much less criticism previously, when the securities retained their values or were increasing in value, which resulted in markups rather than markdowns. Nevertheless, as a result of the extreme price movements, the GAAP rules were modified to provide some relief to the many companies that hold available for sale securites. Today the newer rules allow companies to replace these depressed financial asset market prices in unstable markets with estimated stable market values based on management's best judgment.

Issue #4: Full Disclosure

The full disclosure principle requires that all information that could make a difference in the decisions of financial statement users must be fully and clearly disclosed in the financial statements or the footnotes to the statements. Full disclosure (“visibility”) is particularly important for large and complex items in the financial statements, such as the note assets in the SIVs and the nature of the SIVs themselves. However, due to the complexity and subjectivity of calculations and aggregation of large amounts of different loans, disclosure in many cases was of only marginal help - visibility was limited. Finally, the most detailed disclosures occured at only annual intervals (later revised to quarterly), far too late.

The Rating Companies

Ok, so if we are not accounting experts, can we find people who are? For many years, investors have relied on professional rating companies such as Moodys, Standard and Poors, and Fitch that rate the quality of a company’s securities. In principle, these rating companies are the “experts” who can scrutinize a company’s operations and financial statements and then provide both an expert and an unbiased opinion to guide investors. However, various financial experts are now saying that some rating companies compromised their work in numerous ways, including a lack of independence. Because the rating companies are often paid by the companies that they are rating, there exists the potential for an inherent conflict of interest. It has been asserted that potential clients unhappy with a proposed rating have been able to obtain a change in the person doing the rating work or shop around for a different rating company, but the facts are still unclear. During this time, the Federal Justice Department also began investigation into whether one of the rating companies threatened to use unsolicited negative ratings as a means to force companies to hire the rating service.

As a result of all these issues, the major financial reform Legislation passed by Congress and signed by President Obama in July 2010 made rating agencies legally liable for their ratings opinions, in the same manner as accountants and other professions incur professional liability. Additionally, all references to the use of rating agencies were removed from federal statutes and regulations.

A Lack of Regulation

We have seen that accounting rules are complex and can result in unpredictable asset value changes for complex financial securities. We have seen that the rating agencies did not do a credible job. Despite all this, was someone in authority watching to protect the public? The surprising answer is - “not really”. For example, there was very little regulation of fraudulent and deceptive lending practices. There was virtually no regulation concerning the amount of leverage used by investment companies. There was no regulation or controlled trading of the new and complex securities related to the sub-prime loans. Essentially, trillions of dollars of questionable and complex assets were created with very little regulation.

Putting it all together: What went wrong

Looking back, we can see that what happed was a combination of cascading elements that together created a perfect storm for disaster:

  1. The Federal Reserve System made money easily available, then changed its mind and raised interest rates, first creating a boom in the real estate market and then trapping financially fragile home buyers unable to make loan payments and unable to sell their homes in a suddenly declining market.
  2. In order to make more money, many mortgage lenders had lowered their lending standards to attract less qualified and previously unqualified buyers.
  3. In order to make more money, investment companies purchased risky real estate notes from the mortgage lenders and used the loans to create very complex securities, knowing that many investors did not fully understand the nature and risk of the securities, and the complexity of the accounting rules.
  4. Rating companies may not have analyzed the securities with sufficient independence, rigor, and timeliness, with the result that investors could not really comprehend the quality and potential risk involved.
  5. The accounting rules, especially those concerning entity and valuation, are complex and subjective, requiring the use of numerous assumptions. The valuation rules required reporting of large and unexpected, but unrealized losses.
  6. Investors did not fully understand either the nature of the investment or the meaning of the complex financial statements related to the investments, yet ignored this lack of understanding.
  7. The heavy borrowing (called “leverage”) by the SIVs and also by the buyers who purchased the mortgage-backed securities from the SIVs hugely magnified the size, speed, and scope of the world-wide losses. The borrowed money made it possible to greatly increase the amount of securities that could be purchased, stimulated demand for more, and ultimately spread the toxic assets around the world. Secondly, when the assets began to lose value, an immense crisis was created as the lenders started demanding more cash from the borrowers as collateral to protect the loans. This created forced sales of other assets to obtain the cash, which in turn created additional value losses and started a downward spiral of valuation that reduced asset values around the world.
  8. The Federal government oversight agencies (Securities and Exchange Commission, Federal Reserve, and Treasury Department) did not provide sufficient regulation and compliance oversight to prevent the problem from becoming a major crisis.

By Greg Mostyn, Mission College

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