Was Fair Value Accounting responsible for credit crisis?

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Start of Credit Crunch, Consequences, Losses Incurred

Every bull market that turns into a bubble has similar characteristics; the same have been discovered, experienced and endured in the ongoing credit crisis. The phase before the start of turmoil and mayhem corresponded to a vivid and promising futuristic perception. The soaring profits of the banking industry and sky peaking financial markets signified a steady augmentation of the economy. The residential foreclosure crisis that swept US and progressively the world and dominated the headlines in 2007 has ultimately caused turbulence and instability in the world economy. Intuition of the turbulent financial epoch was first felt in early 2007 over the duration of Sub prime Mortgage Crisis in US. Interest rates were relatively very low in the first part of the decade. The low and attractive interest rates spurred increase in mortgage financing and substantial increases in house prices which encouraged investors such as pension funds, hedge funds and investment banks to seek instruments that offer yield enhancement. Using long term mortgages to pay for home was considered as a good idea but with few important caveats. The need for a substantial down payment, verification of income, an independent valuation are the vital factors one needs to think about before buying a house. Although human nature is such that given enough time and incentives, any endeavour will be corrupted. Eventually what was once a good idea became a farce. The loans were sanctioned without fixed rates, without income verification, without down payments and without legitimate valuations. Prior to 2005, the subprime mortgage loans accounted for approximately 10% of outstanding mortgage loans progressively the consensus kept ticking up and by 2006 figures rose to 13% (Michel G. Crouhy, Robert A. Jarrow and Stuart M. Turnbull). The estimated losses in subprime mortgages of between US$400 and 500 billion may appear large at first sight; however they were just the beginning episodes of the wealth destruction when put into perspective. Helplessly in 2008 major financial upheaval pushed the world economy into its worst crisis in decades.

In this light, it seems important to understand the cause of amplification mechanism that explains why the mortgage crisis caused such large dislocations and turmoil in the financial markets. Numerous bankers, legislators, borrowers and regulators have expressed their views about the cause of the credit crunch. Like the blind men examining the elephant, each has an opinion that has been shaped from his perspective. The main factors blamed for the ongoing crisis are the search for yield enhancement, investment management, agency problems, lax underwriting standards, rating agency incentive problems, poor risk management by financial institutions, the lack of market transparency, the limitation of extant valuation models, the complexity of financial instruments, and the failure of regulators to understand the implications of the changing environment for the financial system. As the consequences of the credit crunch unfolded, an immense concern is been raised against the effectiveness of accounting standards to ensure that financial reporting is providing clear and early information regarding difficulties being encountered by entities. During the ongoing crisis the markets for subprime and some other asset and liability positions have been severely illiquid and disorderly in other respects. Whether valuation frameworks are adding excess volatility to financial statements through the actions they underpin to market prices has been a major conflict-ridden topic of discussion and investigation for policy makers for many years.

This has led various financial institutions and large funds to raise several potential criticisms towards fair value accounting. First, the unrealized losses recognized under fair value accounting may reverse once the economy and the markets recover. Second, market illiquidity may render fair values difficult to measure and thus unreliable. Finally, firms reporting unrealized losses under fair value accounting may yield adverse feedback effects that cause further deterioration of market leading to increase the overall risk of the financial system. Prominent financial experts such as Martin Sullivan, CEO of AIG and Henri de Castries CEO of AXA have singled out fair value and the related wide use of mark to market accounting valuation as a major factor in the crisis.

Fair Value- Definition

FAS 157 (Financial accounting standards) defines fair value as '' 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.'' At the measurement date means the fair value should reflect the conditions that exist at the balance sheet date. In the heat of the debates and the questions raised against the fair value accounting the Securities and Exchange Commission (SEC) and Financial Accounting Standards Board (FASB) announced that the regulating bodies would not suspend this method but reinterpret the rule to give the banks and the auditors more flexibility. The supporting bodies of the FAS 157 explain that it isn't the cause of today's problems and the method protects the investors. Apparently in the middle of the great crisis if everything is thrown onto the table it would be unwise to undo hard won battles. The technique of fair value accounting might be causing pain conversely the rule undeniably supports clients and asset owners by forcing the market to clearly and consistently value instruments and to make the process more transparent.

The emergence of Fair Value Accounting

The technique practiced before fair value was Amortized Cost Accounting (Historical Accounting). In its pure form the procedure uses historical information about future cash flows and risk adjusted discount rates from the inception of positions to account for them throughout their lives on firms balance sheets and income statements. This approach can lead to inefficiencies as adjustments are not made for subsequent changes in market value. The method of historic cost accounting was been practiced for many years but some of the main issues highlighted were considering the asymmetric and unfair information provided to the investors and regulators about the firm. The income earned or generated is persistent as long as firms hold positions but becomes transitory when positions mature or are disposed of and firms replace them with new positions at current market terms and values. This can lull investors into believing that income is more persistent than it really is. Presumably, market failures contributing to valuation problems could be rectified and developed with the help of accounting policies and indeed some policies are aimed to correct imperfections. The accounting standards are instrumental in bridging financial and risk information gaps, they ensure that well defined, comparable financial statements are sensitive to price signals thereby filling the loop holes associated with historical accounting. Historical cost accounting estimates financial assets and liabilities at their origination value. This can lead to inefficiencies as adjustments are not made for subsequent changes in the market value. Considering an example of the value of an asset throughout a business cycle; during the upturn the historical cost valuation may lead to an undervaluation of an asset and conversely during the downturn the asset may be overvalued. In response to the limitations of historical cost accounting an alternate approach seeking to more accurately reflect market valuations the technique of fair value accounting has been introduced.

Should fair accounting be blamed?

The key to the debate is whether fair value accounting injects excessive volatility into transactions prices and hence valuing the assets according to the market trends. The opposition to marking to market has been has been led by the banking and insurance fraternity whereas the equity investors have been the most enthusiastic proponents for marking to market. Banks and other intermediaries always respond to changes in economic environment, but marking to market sharpens and synchronises their responses adding impetus to the feedback effects in financial markets. Implementing and practisicing factual standards of accouting is relevant because we live in an imperfect world, where markets are not fully liquid and incentive may be distorted and the transaction prices may not be readily available. In practice one can expect wider overlaps between the interest of equity investors, creditors and wider public interest. The choice of an accounting measurement regime for financial institutions is one of the most contentious policy issues being faced by the financial regulators and accounting standard setters at the moment. However market value of an asset or liability is more relevant than the historical cost at which it was purchased or incurred because the market value reflects the amount at which that asset or liability could be bought or sold in a current transaction between the willing parties. With the politicians(regulators) and the investors(consumers) the two sides of the coin are looking for someone to blame for the economic crisis, fair value has become a convenient scapegoat. Since the happening of the Enron and Aircom scandal fair value accounting is blamed at best for contributing to the collapse of the banking system, at worst for being one of its root causes. Thomas Jones, vice chairman of the International Accounting Standards Boards commented," It is a lousy system, but it is less lousy than any other system ... and I don't find that the people who criticize fair value have very good ideas for an alternative," asserted Jones, who was speaking at a financial reporting conference sponsored by the New York Society of Security Analysts. The alternatives include traditional historic cost accounting, averaging the values, basing values on contractual amounts, and what Jones described as "what you wished it was" or "what it ought to be".

Fair value accounting creates mayhem when securities and trades are in trouble, when value has collapsed and assets are marked dirt cheap or worse. The toxic collateralised debt obligation were considered one of the favourite investment tolls of the fund managers but no one wants to go near them now, which means banks have had to mark down the value of their investments. The crticisms against fair value was never a part of the bullish phase of the market, blaming fair value techniques for the ongoing recession is like blaming the war on guns.