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Fair Value Accounting and the Subprime Mortgage Crisis Research Paper

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Updated: Apr 10th, 2020

Introduction

The use of fair value or mark-to-market accounting is extremely widespread among various organizations, including those ones that represent the financial services industry. This method is also advocated by investors who need to estimate the price of various assets. This approach has often been criticized during the economic and financial recession which broke out in 2007. Much attention is often paid to the sub-prime mortgage crisis which triggered the downfall of several financial institutions such as Lehman Brothers.

This paper is aimed at describing the peculiarities of this method. Furthermore, it is critical to determine to what extent fair value accounting could contribute to the subprime crisis. Overall, one can argue that this method of accounting should not be regarded as the underlying cause of the sub-prime crisis. Instead, more attention should be paid the internal inefficiencies within financial institutions, especially lack of proper risk management strategies since these problems increased the vulnerability of various banks.

Certainly, one should keep in mind that fair value cannot always be used to predict the long-term changes in the price of an asset. Nevertheless, from the investors’ viewpoint, this indicator is the most objective one. This is the main thesis that should be discussed more closely. Overall, these details can have profound implications for different stakeholders.

The main peculiarity of fair value accounting

It should be noted that the term fair value can be defined as the estimation of a product’s worth provided that it is sold in the open market (Penman 169). It should be mentioned that there is no clear algorithm for determining this price. In many cases, this task has to be performed by an independent appraiser. One should also keep in mind that the fair value of an asset is regularly updated.

The concept of fair value should be distinguished from historical cost which is used to describe the price at which a certain asset was purchased by the owner. In many cases, the use of historical costs is very inaccurate because the value of an asset can change dramatically with time passing (Penman 167). As a rule, organizations rely on fair value accounting in order to determine the worth of their assets while reporting their financial performance. To a great extent, this approach has become a gold standard in various industries.

The use of fair value accounting is also advocated by investors. Moreover, it is recognized by governmental institutions such as the Financial Accounting Standards Board. These are some of the key issues that should be taken into account. At this point, it is important to examine the key events that lead to the sub-prime crisis which affected millions of people.

Sub-prime crisis

One should keep in mind that the value of mortgage-backed securities was based primarily on the price of real estate. Since the early 2000s, these prices were continuously rising and very few investors saw the signs of a housing bubble as well as the irrational behavior of many buyers (McDonald and Stokes 1104). For a long time, they assumed that the price of housing would remain relatively high (McDonald and Stokes 1104). Additionally, one should mention that the loans could often be given to people who could not repay them.

Many of them could be affected by such problems as unemployment. This is why such mortgages were called sub-prime. However, these risks were overlooked because people were firmly convinced that real estate could guarantee the security of mortgage-backed assets.

The attitudes of investors changed dramatically when the rates of foreclosures increased while the price of housing decreased dramatically (Adjei 80). These issues are important for understanding the topic; in particular, this information can a person evaluate the criticisms of fair value accounting and the way in which this method could be related to the sub-prime crisis.

The use of this method and sub-prime mortgage crisis

Criticisms offered the opponents of fair value accounting

Overall, the critics of fair value accounting put forward several arguments in order to demonstrate that this method intensified the effects of the sub-prime mortgage crisis. One of the main points is that the use of this method significantly diminished the capital base of various banking institutions. Apart from that, the representatives of these organizations note that they did not intend to sell mortgage-backed securities at extremely low prices.

Moreover, in their belief, market prices did not really throw light on the long-term value of assets (Badertscher, Burks, and Easton 62). To a great extent, this argument implies that many banks could be brought to the brink of bankruptcy due to market panic; however, their financial performance could be sound. It should be kept in mind that regulating institutions are required to declare that a bank is at the risk of financial collapse if the fair value of its assets diminishes dramatically.

In addition to that, the critics of fair-value accounting state that many investors do not rely on valid information which making purchasing or selling decisions (Valencia, Smith, and Ang 694). In this case, the term information can include facts about the financial performance of any organization, return on investment, competition, and so forth. In many cases, they pay more attention to noise or daily fluctuations in the price of an asset (Valencia Smith, and Ang 693).

Apart from that, the fair-value marketing can cause the fire-sale of assets. This argument is particularly relevant if one speaks about such financial institutions as Lehman Brothers and Northern Rock. The main cause of their downfall was cash flow insolvency which emerged due to the use of fair value accounting.

This is why the representatives of financial institutions call for a different method of evaluating the assets of financial organizations and enterprises. This is one of the aspects that should be distinguished since it is vital for understanding the potential limitations of this approach and delineating the scope of this method.

To a great extent, this discussion can be tied to the so-called efficient market hypothesis. It is the assumption according to which the prices accurately reflect the information about different securities or stocks. Nevertheless, the validity of this hypothesis is often questioned. It should be kept in mind that traders can misinterpret financial trends (Frydman and Goldberg 120).

These are some of the main criticisms identified by researchers. One should also bear in mind that when reacting to noise, people are more likely to display a downward bias (Frydman and Goldberg 120). In other words, they tend to make pessimistic predictions about the performance of financial assets, including mortgage-backed securities. Sometimes, these estimations can be driven by panic, rather than impartial evaluation (Frydman & Goldberg 120).

These results indicate that fair-value accounting could misguide the decisions of investors. It seems that these results should not be overlooked because they suggest that the fair value is not necessarily impartial. This detail should be recognized by policy-makers and investors.

Apart from that, this issue should not be overlooked by people who design risk-management policies of financial organizations; by considering the information about accounting methods, these people will pinpoint and eliminate the key weaknesses in the work of businesses. These are some of the points that can be made.

Apart from that, one should take into account that the fair value of assets can be very difficult to estimate. Moreover, there are different methods that can be applied in order to estimate the price at which certain security can be purchased. Overall, this issue indicates that the notion of fair value can be valid provided that there is an impartial way for appraising the worth of such securities. This argument is particularly relevant if one speaks about securities backed up by sub-prime mortgages.

The fair value prices of these assets were very high for the long term; however, they did not reflect the long-term worth of such assets. This is why researchers argue that it is necessary to use both fair value and historical cost accounting. In their opinion, mark-to-market accounting is not quite suitable when it is necessary to evaluate the worth of assets with a long-term holding period. The critics of fair-value accounting argue that this method reflects the beliefs of investors about the potential price of an asset (Andrews).

However, in itself, accounting is not aimed at proving forecasts (Andrews). These are the main limitations that should be taken into account. Yet, one should consider the arguments made by the supporters of this tool because, in this way, one can identify the strengths and weaknesses of this accounting method.

Defense of fair value accounting

Overall, it is important to mention that this criticism of fair value accounting cannot be fully accepted. One should bear in mind that fair value accounting could simply be regarded as a convenient excuse for the inefficient work of banking institutions, especially those ones which strongly relied on mortgage-backed securities. They did not fully consider the impact of possible risks. This is one of the issues that are not closely discussed by critics of fair value accounting.

Therefore, scholars want to test the criticisms of this method in an empirical way. Furthermore, researchers note that financial institutions perceive fair-value accounting as a “scapegoat” (Badertscher, Burks, and Easton 59). Instead, they should have paid more attention to internal inefficiencies and the failure to consider the risks of relying on mortgage-based securities. This is one of the aspects that should be recognized. Researchers tested the arguments put forward by the critics of fair value accounting.

In particular, they examined the functioning of 150 leading banks working in the United States. They did not find sufficient evidence which can prove that the losses of banks could be explained by the use of mark-to-market accounting. Moreover, the existing regulations did not necessarily force banking institutions to “respond to capital-depleting charges” (Badertscher, Burks, and Easton 59).

Moreover, they state that “fair value accounting losses” did not significantly affect the regulatory capital of many banks (Badertscher, Burks, and Easton 59). These are some of the main aspects that can be distinguished.

This case is important for showing that one should not blame this approach to accounting for the failures of various institutions because this perception can make a person overlook the underlying causes of the sub-prime crisis. For instance, one can mention such a problem as the inability to make financial institutions more responsive to external stressors such as the fluctuations in the prices of certain goods.

Furthermore, one should keep in mind that fair value accounting affected a certain type of assets, in particular, mortgage-based securities. However, it did not influence other stocks or bonds. Therefore, one can assume that the risk management policies of these banks could be flawed. This argument can be particularly relevant if one speaks about such financial institutions as Lehman Brothers.

Apart from that, it is important to mention that the representatives of financial institutions did not object to the use of fair value accounting at the time when the price of mortgage-based securities was relatively high. They did not state that the use of this tool could lead to significant problems. They did not pay much attention to the risks of fair value accounting and their long-term impacts. This is why the criticisms offered by banking institutions can be questioned.

Additionally, this question should be examined from the perspective of investors. These individuals and organizations prefer to rely on fair value accounting in order to estimate the worth of any financial asset. In their opinion, it is the most transparent way of appraising the worth of assets. Certainly, the fluctuations of the prices can provoke irrational behavior, but at present, this indicator is the most valid measurement. Furthermore, these people cannot rely on the estimations offered by a company because these estimations can lack transparency. The opinions of investors are often overlooked by the critics of fair value accounting. Therefore, this method cannot be dismissed by financial organizations as well as investors who need to make judgments about the value of stocks or securities.

Discussion

To a great extent, these examples show that fair value accounting should not be blamed for the onset of the sub-prime mortgage crisis. Admittedly, investors could overreact to the fluctuations in the price of securities. In some cases, such behavior can be irrational, and it can increase the volatility of financial institutions.

Therefore, some of them could fail due to panic in the market, rather than lack of capital. Nevertheless, many of the banks could be vulnerable because they relied strongly on mortgage-based securities. This is why they could not respond to the risk of external stressors such as the changing prices of real estate. However, their failures cannot be attributed to fair value accounting. Furthermore, one can say that this approach can still be regarded as a gold standard. This is the main arguments that can be advanced.

Conclusion

Despite the potential limitations of fair value accounting, it remains the most optimal method for evaluating the worth of securities. One should mention that the sub-prime mortgage crisis can be explained by several factors. In this case, much attention should be paid to the lack of appropriate risk management strategies which are critical for increasing the sustainability of financial institutions.

Certainly, in many cases, investors can take irrational decisions, even when they make judgments on the basis of fair-value prices. This risk should not be overlooked, but the problems do not undermine the validity of mark-to-market accounting because this method is most transparent and informative. These are the main details that can be singled out.

Works Cited

Adjei, Frederick. “The sub-prime mortgage crisis and the changing value of cash.” Journal of Economic and Finance 33.4 (2011): 79-92. Print.

Andrews, Edmund. “Stanford Business Experience. 2014. Web.

Badertscher, Brad, Jeffrey Burks, and Peter Easton. “A Convenient Scapegoat: Fair Value Accounting by Commercial Banks during the Financial Crisis.” The Accounting Review 81.1 (2012): 59-90. Print.

Frydman, Roman, and Michael D. Goldberg. Beyond Mechanical Markets : Asset Price Swings, Risk, And The Role Of The State, Princeton: Princeton University Press, 2011. eBook Academic Collection (EBSCOhost). Web.

McDonald, John and Houston Stokes. “The housing price bubble, the monetary policy and the foreclosure crisis in the US.” Applied Economics Letters 20.11 (2013): 1104-1108. Print.

Penman, Stephen. Accounting For Value, New York: Columbia University Press, 2011. eBook Academic Collection (EBSCOhost). Web.

Valencia, Adrian. Thomas Smith, and James Ang. “The Effect of Noisy Fair Value Measures on Bank Capital Adequacy Ratios.” Accounting Horizons 27.4 (2013): 693-710. Print.

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IvyPanda. (2020, April 10). Fair Value Accounting and the Subprime Mortgage Crisis. Retrieved from https://ivypanda.com/essays/fair-value-accounting-and-the-subprime-mortgage-crisis/

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IvyPanda. 2020. "Fair Value Accounting and the Subprime Mortgage Crisis." April 10, 2020. https://ivypanda.com/essays/fair-value-accounting-and-the-subprime-mortgage-crisis/.

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