FAIR VALUE ACCOUNTING

AND SUBPRIME
CASE STUDY
ADVANCED ACCCOUNTING

SUBMITTED TO:
LOUIE ARTH REYES

SUBMITTED BY:
Aquino, Mary Claire C.
Cabaya, Eula C.
Crisostomo, Meryl
Enriquez, Pauline C.
Magno, Franz Catherine S.
Magparok, Catherine
Orate, Rhealy B.
 I. BACKGROUND OF THE CASE

The subprime mortgage crisis occurred when banks sold too many mortgages to feed the
demand for mortgage-backed securities sold through the secondary market. When home
prices fell in 2006, it triggered defaults. The risk spread into mutual funds, pension funds,
and corporations who owned these derivatives. The ensuing 2007 banking crisis and the
2008 financial crisis produced the worst recession since the Great Depression.

Here's the timeline from the early warning signs in 2003 to the collapse of the housing
market in late 2006. Keep reading to understand the relationship between interest rates,
real estate, and the rest of the economy.

February 21, 2003: Buffett Warns of Financial Weapons of Mass Destruction

The first warning of the danger of mortgage-backed securities and other derivatives came
on February 21, 2003. That's when Warren Buffett wrote to his shareholders, “In our view,
however, derivatives are financial weapons of mass destruction, carrying dangers that,
while now latent, are potentially lethal.”

June 2004-June 2006: Fed Raised Interest Rates

By June 2004, housing prices were skyrocketing. The Federal Reserve Chairman Alan
Greenspan started raising interest rates to cool off the overheated market. The Fed raised
the fed funds rate six times, reaching 2.25 percent by December 2004. It raised it eight
times in 2005, rising two full points to 4.25 percent by December 2005. In 2006, the new
Fed Chair Ben Bernanke raised the rate four times, hitting 5.25 percent by June 2006.
Disastrously, this raised monthly payments for those who had interest-only and other
subprime loans based on the fed funds rate. Many homeowners who couldn't afford
conventional mortgages took interest-only loans as they provided lower monthly payments.
When home prices fells, many found their homes were no longer worth what they paid for
them. At the same time, interest rates rose along with the fed funds rate. As a result, these
homeowners couldn't pay their mortgages, nor sell their homes for a profit. Their only
option was to default. As rates rose, demand slackened. By March 2005, new home sales
peaked at 127,000.

August 25-27, 2005: IMF Economist Warns the World's Central Bankers
Dr. Raghuram Rajan was chief economist at the World Bank in 2005. He presented a paper
entitled, "Has Financial Development Made the World Riskier?" at the annual Economic
Policy Symposium of central bankers at Jackson Hole, Wyoming. Rajan’s research found
that many big banks were holding derivatives to boost their own profit margins.He warned,
"The inter-bank market could freeze up, and one could well have a full-blown financial
crisis," similar to the Long-Term Capital Management crisis. The audience scoffed at
Rajan’s warnings, with Former Treasury Secretary Larry Summers even calling him a
Luddite.

December 22, 2005: Yield Curve Inverts

Right after Rajan's announcement, investors started buying more Treasurys, pushing yields
down. But they were buying more long-term Treasurys, maturing between three to 20
years, than short-term bills, with terms ranging from one month to two years. That meant
the yield on long-term Treasury notes was falling faster than on short-term notes. By
December 22, 2005, the yield curve for U.S. Treasurys inverted. The Fed was raising the
fed funds rate, pushing the 2-year Treasury bill yield to 4.40 percent. But yields on longer-
term bonds weren't rising as fast. The 7-year Treasury note yielded just 4.39 percent. This
meant that investors were investing more heavily in the long term. The higher demand
drove down returns. Why? They believed a recession could occur in two years. They
wanted a higher return on the 2-year bill than on the 7-year note to compensate for the
difficult investing environment they expected would occur in 2007. Their timing was
perfect. By December 30, 2005, the inversion was worse. The 2-year Treasury bill returned
4.41 percent, but the yield on the 7-year note had fallen to 4.36 percent. The yield on the
10-year Treasury note had fallen to 4.39 percent. By January 31, 2006, the 2-year bill yield
rose to 4.54 percent, outpacing the 10-year’s 4.49 percent yield. It fluctuated over the next
six months, sending mixed signals. By June 2006, the fed funds rate was 5.75 percent,
pushing up short-term rates. On July 17, 2006, the yield curve seriously inverted. The 10-
year note yielded 5.06 percent, less than the three-month bill at 5.11 percent.

September 25, 2006: Home Prices Fall for the First Time in 11 Years
The National Association of Realtors reported that the median prices of existing home sales
fell 1.7 percent from the prior year. That was the largest such decline in 11 years. The price
in August 2006 was $225,000. That was the biggest percentage drop since the record 2.1
percent decline in the November 1990 recession. Prices fell because the unsold inventory
was 3.9 million, 38 percent higher than the prior year. At the current rate of sales of 6.3
million a year, it would take 7.5 months to sell that inventory. That was almost double the
four-month supply in 2004. Most economists thought it just meant the housing market was
cooling off, though. That’s because interest rates were reasonably low, at 6.4 percent for a
30-year fixed-rate mortgage.

November 2006: New Home Permits Fall 28 Percent

Slowing demand for housing reduced new home permits 28 percent from the year before.
This leading economic indicator came in at 1.535 million, according to the November 17
Commerce Department Real Estate Report. New home permits are issued about six months
before construction finishes and the mortgage closes. This means that permits are a leading
indicator of new home closes. A slump in permits means that new home closings will
continue to be in a slump for the next nine months. No one at the time realized how far
subprime mortgages reached into the stock market and the overall economy. At that time,
most economists thought that as long as the Federal Reserve dropped interest rates by
summer, the housing decline would reverse itself. What they didn't realize was the sheer
magnitude of the subprime mortgage market. It had created a "perfect storm" of bad events.
Interest-only loans made a lot of subprime mortgages possible. Homeowners were only
paying the interest and never paying down principal. That was fine until the interest rate
kicker raised monthly payments. Often the homeowner could no longer afford the
payments. As housing prices started to fall, many homeowners found they could no longer
afford to sell the homes either. Voila! Subprime mortgage mess. Mortgage-backed
securities repackaged subprime mortgages into investments. That allowed them to be sold
to investors. It helped spread the cancer of subprime mortgages throughout the global
financial community. The repackaged subprime mortgages were sold to investors through
the secondary market. Without it, banks would have had to keep all mortgages on their
books. Interest rates rule the housing market, as well as the entire financial community. In
order to understand interest rates and the role it plays, know how interest rates are
determined and what the relationship between Treasury notes and mortgage rates is. Also,
have a good basic understanding of the Federal Reserve and Treasury notes. Before the
crisis, real estate made up almost 10 percent of the economy. When the market collapsed,
it took a bite out of the gross domestic product. Although many economists said that the
slowdown in real estate would be contained, that was just wishful thinking. Moreover, As
home prices fell, bankers lost trust in each other. They were afraid to lend to each other
because if they could receive mortgage-backed securities as collateral. Once home prices
started falling, they couldn't price the value of these assets. But if banks don't lend to each
other, the whole financial system starts to collapse.

Reference:https://www.thebalance.com/subprime-mortgage-crisis-effect-and-timeline-
3305745
II. STATEMENT OF THE PROBLEMS

1. What is the primary cause of the current financial crisis?

2. Does historical cost accounting has connection with current market value?
3. Did Fair-Value Accounting contribute to the Financial Crisis
4. Are most assets of financial institutions marked to market?

III. PRESENTATION OF DATA

1. Deregulation in the financial industry was the primary cause of the financial
crash. It allowed speculation on derivatives backed by cheap, wantonly-
issued mortgages, available to even those with questionable
creditworthiness. Rising property values and easy mortgages attracted a lot
of people to avail of home loans. This created the housing market bubble.
When the Fed raised interest rates, the consequential increased mortgage
payments squeezed home borrowers’ abilities to pay. Since home loans
were intimately tied to hedge funds, derivatives, and credit default swaps,
the resounding crash in the housing industry drove the U.S. financial
industry to its knees as well. With its global reach, the U.S. banking industry
almost pushed most of the world’s financial systems to near collapse as
well. To prevent this, the U.S. government was forced to implement
enormous bail-out programs for financial institutions previously billed as
“too big to fail.”

The 2008 financial crisis has similarities to the 1929 stock market crash.
Both involved reckless speculation, loose credit, and too much debt in asset
markets, namely, the housing market in 2008 and the stock market in 1929.

2. Fair value proponents argue that historical costs of assets on a company’s

balance sheet often bear little relation to their current value. Under historical
cost accounting rules, most assets are carried at their purchase price or
original value, with minor adjustments for depreciation over their life (as in
the case of buildings) or for appreciation until maturity (as in the case of a
bond bought at a discount to par). A building owned by a company for
decades, therefore, is likely to appear on the books at a much lower value than
it would actually command in today’s market.

However, even under historical accounting, current market values are

factored into financial statements. U.S. regulators require all publicly traded
companies to scrutinize their assets carefully each quarter and ascertain
whether they have been permanently impaired—that is, whether their market
 value is likely to remain materially below their historical cost for an extended
period. If the impairment is not just temporary, the company must write the
asset down to its current market value on its balance sheet—and record the
resulting loss on its income statement.

3. Its pure form, fair-value accounting involves reporting assets and liabilities
n its pure form, fair-value accounting involves reporting assets and
liabilities on the balance sheet at fair value and recognizing changes in fair
value as on the balance sheet at fair value and recognizing changes in fair
value as gains and losses in the income statement. The recent financial crisis
has led to a major debate about fair-value accounting. Many critics have
argued that fair-value accounting, often also called mark-to-market
accounting, has significantly contributed to the financial crisis or, at least,
exacerbated its severity. In this paper, we assess these arguments and
examine the role of fair-value accounting in the financial crisis using
descriptive data and empirical evidence. Based on our analysis, it is unlikely
that fair-value accounting added to the severity of the current financial crisis
in a major way. While there may have been downward spirals or asset-fire
sales in certain markets, we find little evidence that these effects are the
result of fair-value accounting. We also find little support for claims that
fair-value accounting leads to excessive write-downs of banks' assets. If
anything, empirical evidence to date points in the opposite direction, that is,
towards overvaluation of bank assets.

4. There has been a spirited debate about the merits of mark-to-market

accounting for financial institutions for some time now. Many argue that
market prices provide the best estimate of value available and should always
be used. However, others suggest that in times of crisis market prices are
not a good reflection of value and their use can lead to serious distortions.
This article explains the circumstances where market prices do reflect future
earning power and those where market imperfections imply that they do not.
We suggest that in financial crisis situations where liquidity is scarce and
prices are low as a result, market prices should be supplemented with both
model-based and historic cost valuations. The rest of the time and in
particular when asset prices are low because expectations of future cash
flows have fallen, mark-to-market accounting should instead be used.

Most securities are classified as “held to maturity,” and therefore, under

U.S. GAAP, are carried on balance sheets at historical cost. Only in the
event of permanent impairment will a change in their value affect banks'
income and regulatory capital. By contrast, all traded assets are marked to
market each quarter.
 IV. CONCLUSION

We therefore conclude that financial system and the economies of a number of states in
different parts of the world were shaken by the subprime mortgage crisis. Moreover, the
proposed conceptual framework would shift the determination of income from the income
statement and its emphasis on the matching of costs with related revenues to the
determination of income by measuring the “well offness” from period to period by
measuring changes on the two balance sheets on a fair value basis from the beginning and
the ending of the period. The argument was made that these data are more relevant than
the historic cost in use and not as subjective as the concept of identifying costs with related
revenues. In addition, those in favor of the change claimed that the fair value data was more
relevant than the historic cost data and thus more valuable to the possible lenders and
investors, ignoring the needs of the actual managers and, in the case of private companies,
the owners.