GLOBAL FINANCIAL

CRISIS
Accounting 101 group report

Group members:

Angelia Wibawa 42190010

Jessika Wen 41915186
Maree Caristo 42127009
Michelle Bartolo 41762673
Redmond Reyes 42102383

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 Table of Content

BRIEF INTRODUCTION & REPORT OBJECTIVE...........................................................................3

ESSENCE OF THE GLOBAL FINANCIAL CRISIS...........................................................................4

TRANSMISSION MECHANISMS......................................................................................................4

SIGNIFICANCE OF THE US HOUSING BUBBLE TO THE CRISIS...............................................6

FAIR VALUE ACCOUNTING AND THE FINANCIAL CRISIS.......................................................8

CONCLUSION...................................................................................................................................10

REFERENCES....................................................................................................................................11

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BRIEF INTRODUCTION & REPORT OBJECTIVE

Spearheaded by emerging economies, the world has witnessed a nascent economic recovery

since the global financial crisis took off. However, progression is sluggish and the world is

still yet to experience a sustainable re-growth till today. This report seeks to analyse the

global phenomenon and recognise the mechanisms that have transmitted he ripple effect of

the crisis to different countries’ economy. In analysing the crisis, relevance of the United

States housing bubble in the evolution of the crisis would also be discussed. Lastly, a

resolution over the controversy that fair value accounting could possibly be blamed for the

crisis would be proposed.

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ESSENCE OF THE GLOBAL FINANCIAL CRISIS (2007-present)

Sparked off by a liquidity deficit in the US banking system (characterised by a credit crunch),

the global financial crisis has culminated in the downfall of large financial institutions,

frenzied banks bailout by various national governments (e.g. Lehman Brothers) and global

stock markets destabilising. It is arguably the worst financial crisis since the Great

Depression (1920s). (Catanach & Ragatz, 2010)

TRANSMISSION MECHANISMS

Due to globalisation, the world economy is highly inter-connected. As such, the economic

effect of the crisis originating from the US has a trickle-down effect throughout the world

economy, transmitted via specific mechanisms.

1.       Exposure of the world’s financial system to the US financial system (Mortgage

industry)

The significance of the US housing and mortgage markets in the world economy is reinforced

by the long exposure of overseas financial capital to US mortgages, where overseas banks

helped finance the sub-prime mortgage market and the US housing boom. Consequently, the

crisis left these overseas financial institutions (e.g. BNP Paribas in France, Halifax Bank of

Scotland in UK) with worthless sub-prime assets and difficulties to gain back their much-

needed capital, hence suffering liquidity losses that in turn adversely affect their home

country’s economy. This impact was felt worldwide instantly, accelerated by the electronic

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transferability of money and the fact that national capital markets operate based on

expectations and reciprocal signals. (Forster, 2010)

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 2.       The real economy (through links on international demand and supply of finished

goods and inputs)

In the US, rampant foreclosures, coupled by falling housing prices eroded the income of

financial institutions holding mortgages and their lending ability. Consequently, retail

borrowing and spending, especially on big-ticketed items that require loans (e.g. cars) got

adversely affected. Declining sales in affected industries created cutbacks for demand from

overseas suppliers, in turn reducing these countries’ income. (Forster, 2010)

Also, US’ dwindling import demand exposes export-reliant countries (e.g. Japan) to the full-

force impact of the crisis (Tantisantiwong, 2010). Given the global nature of Asian products

and services, a downturn in wealthy countries amplifies the chances of economic slowdown

in Asia, which entails the risk of job losses and likely social unrest. Enormous reciprocal

investments in Western countries further incite inevitable knock-on effects upon Asian

currency and stock markets. Moreover, foreign investment and much-needed aid in poor

countries like Africa are likely to diminish as countries desperately try to salvage their own

economy instead. (Athukorala & Chongvilaivan, 2010)

However, different countries suffer varying degree of losses depending on their individual

financial openness, susceptibility to external forces and economic policies.

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SIGNIFICANCE OF THE US HOUSING BUBBLE TO THE CRISIS

Hypothesised by many as the root causal agent of the global phenomenon, the US housing

bubble is indeed the driving factor for financial institutions to support sub-prime mortgages

which marks the turning point of the then-flourishing US economy.

Perceived to be a more reliable form of investment, the stock market crash and the dot-com

bubble burst had led many people diverting to real estate investment. Real estate became the

primary outlet for the speculative frenzy (“irrational exuberance”) that the stock market had

previously unleashed. In response to the stock market crash, the Federal Reserve Board cut

federal funds rate to historically low interest rate of 1% (mid 2003). This unsustainable move

made mortgage borrowing cheap, which fundamentally engendered the housing bubble.

(Wickerham, 2008)

Such cheap credit induced many financial institutions to undertake substantial leveraging.

Encouraged by the housing bubble, they borrowed heavily to purchase home mortgages from

lenders, which would be repackaged into CDOs (Collateral debt obligations) to be sold to

investors. Fannie Mae and Freddie Mac were active players in this market because they

created securities in mortgages.

Higher returns for investors created high demand for more mortgages. However, eventual

saturation in the mortgage market forced these institutions to turn to the sub-prime market

(relaxation of underwriting standards). (Wallace, 2008)  Default and foreclosures were not a

concern to them as it simply required selling the houses to recoup losses, especially supported

by the rising house prices. Besides, default risk would be passed on to the next party in each

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transaction. (Kamin & DeMarco, 2010)

Not surprisingly, default rate among sub-prime home owners surged, causing the supply of

houses put up on sale to exceed demand. This caused housing prices to plummet.

Consequently, despite being able to afford monthly re-payments, the other mortgagors

became unwilling to pay their mortgages, given the tremendous fall in their houses’ value,

resulting in further defaults. Large banking institutions and various investors holding these

worthless financial instruments (CDOs) became heavily indebted. The pooling of sub-prime

mortgage debts aggravated the systemic risk and the whole financial system faltered.

(Forster, 2010)

In essence, the US housing bubble had sparked off excessive provision of sub-prime

mortgages. The collapse of the US sub-prime mortgage market and the consequent reversal of

the housing boom eventually triggered the meltdown of the US financial system. These

ultimately propelled the ripple effect worldwide, hence accounting for the significance of the

US housing bubble in the development of the global financial crisis.

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FAIR VALUE ACCOUNTING AND THE FINANCIAL CRISIS

The financial crisis has also led to an ongoing dispute over whether fair value accounting

(also called mark-to-market accounting) has caused the financial crisis or amplified its

severity.

Current dynamic and volatile markets illustrate the importance of deciding to buy or sell, and

understanding how much an asset is presently worth. Fair value is the most relevant method

to measure and report these financial assets as it is based on market measures and estimates.

(Pozen, 2009) Fair value is defined by the Financial Accounting Standards board (FASB,

2006) as “the price that would be received to sell an asset or paid to transfer a liability taking

place in an active market”, and it provides more transparency than historical cost-based

measurement. (Laux & Leuz, 2010)

Bankers’ allegations against fair value accounting were due to the unforeseen freezing of

credit markets in late 2008, in which fair value accounting system drove clearing prices of

key assets (mortgages, corporate bonds, and structured debts) to unparalleled lows, below

their actual values. This consequently pressured many banks towards bankruptcy, forcing

them to discharge assets at fire-sale prices, further driving their values down. (Pozen, 2009)

However, shareholders claim that marking-to-market is all the more essential under such

crisis environment. In the absence of marking-to-market treatment, investors might continue

purchasing mortgage securities at higher prices, since the full impact of increasing default

rate captured by fair-value data would not be available. Abolishing fair-value treatment

merely conceals the true economics of the situation temporarily, since losses and its full

consequences would eventually still actualise, evident in the earnings over time. (Wallace,

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2008).

Fair value accounting essentially attempts to capture market price changes appropriately and

in a timely manner, thus providing any warning signal for future crisis. In the context of the

crisis, acknowledging losses from higher default expectations (mispricing problems) sooner,

would encourage banks to take appropriate measures to address the problem earlier, hence

preventing a potentially more severe scenario (Wallace, 2008).

Some financial institutions further argued that market illiquidity (during the credit crisis) may

render measurement of fair values difficult and unreliable. However, FASB had responded by

providing new rules that grant more flexibility for securities to be marked to model, rather

than market, only with additional disclosure requirements. (Ryan, 2009)

Therefore, fair value accounting is unlikely to have contributed to the severity of the crisis

significantly, as there is little verification that any downward spiral effects are its direct

outcomes (Magnan, 2009). In our view, fair value accounting is just the messenger that

simply communicated the consequence of the various poor decisions (granting sub-prime

loans etc) responsible for the crisis instead. (Pozen, 2009)

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CONCLUSION

Initially a relatively localised issue within US, the crisis has had a substantial and impactful

flow-on effect worldwide. The sluggish global economic recovery so far seems indicative

that the impact of the global phenomenon is yet fully over. Several theories and hypothesises,

such as the controversy over fair value accounting have been put forth, attempting to account

for the crisis. However, given the complexity and scale of the crisis, it is imperative to

consider the various perspectives and factors objectively and simultaneously before alleging a

factor as the sole culprit.

1499 words
(Excluding citations & references)

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REFERENCES

Athukorala., P. & Chongvilaivan, A. 2010, ‘The Global Financial Crisis and Asian

Economies.’ ASEAN Economic Bulletin, vol 27, no. 1 pp. 1-4.

Catanach., A. & Ragatz, J. 2010, ‘2008 Market Crisis: Black Swan, Perfect Storm or Tipping

Point?’ Bank Accounting & Finance, vol 23, no.3, pp. 20-26.

Financial Accounting Standards Board (FASB), 2006. ‘Statement of financial accounting

standards’ No. 157: Fair value measurements. Norwalk, CT:FASB

Forster, J. 2010, ‘The Global Financial Crisis, Implications for Australasian Business’

Griffith Business School/Griffith University, John Wiley and Sons Australia,Ltd.

Kamin, S., & DeMarco, L. 2010, ‘How Did a Domestic Housing Slump Turn into a Global

Financial Crisis?’ Working Papers -- US Federal Reserve Board's International Finance

Discussion Papers.

Laux .C. & Leuz. C. 2010, ‘Did Fair-Value Accounting Contribute to the Financial Crisis?’

Journal of Economic Perspectives, American Economic Association, vol. 24 no. 1, pp. 93-118

Laux. C. & Leuz. C. 2009, ‘The crisis of fair value accounting: Making sense of the recent

debate’ Accounting, Organisations and Society, vol. 34 pp. 826-834.

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Magnan., M. 2009, ‘Fair Value Accounting and the Financial Crisis: Messenger or

Contributor?’ Accounting Perspectives, vol. 8 no.3 pp. 189-213.

Pozen, R. 2009, ‘Is It Fair to Blame Fair Value Accounting for the Financial Crisis?’

Harvard Business Review, vol. 87, no.11, pp. 84-92.

Ryan, S. 2009, ‘Fair Value Accounting: Policy Issues Raised by the Credit Crunch.’

Financial Markets, Institutions & Instruments, vol 18, no.2, pp. 163-164.

Tantisantiwong, N. 2010, ‘Should Exports Be Globally Diversified or Regionally

Integrated?’ ASEAN Economic Bulletin, vol 27, no. 1, pp. 55-76.

Wallace, M. 2008, ‘Is Fair-Value Accounting Responsible for the Financial Crisis?’ Bank

Accounting & Finance pp. 9-18.

Wickerham, M. 2008, ‘US housing bubble was created by Fed.’ Christian Science Monitor,

vol. 101, no.16, pp. 8-8.

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