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Following the downfall of Lehman Brothers, attention was focused on the role of regulators and credit rating agencies in the whole debacle. The public demanded for answers which were not forthcoming from all the concerned parties. This experience was to throw the Sarbanes-Oxley Act under close scrutiny and questions were abound as to how the act was not followed by all concerned parties.
The Sarbanes-Oxley Act was enacted to protect and control the activities of shareholders and prevent accounting errors. This act restricted considerably all financial activities and corporate independence, still, the attempt was made, and the results were expected. Credit rating agencies were blamed for coming up with false ratings on securities connected to subprime mortgages. Examples of these agencies are Moodys, Standard, and Poors.
They were found guilty of assigning exceptionally high ratings to the securities and failing to reexamine the ratings based on the current environment at the time. There was also the issue of autonomy as it was found that the rating agencies did not operate independently as there was a conflict of interest in the rating firms. The rating agencies are often backed up by the issuer who owns the bond that the same agencies rate.
The situation with Lehman Brothers Holdings showed that the grounds for its downfall were observed through evident accounting malpractice that was committed by both management and staff. The representatives from all departments did not find it necessary to control the financial activities of the organization, still, they try to get more personal benefits and provide their families with appropriate incomes.
Managers got an access to manipulate net profits in order to please the public as well as to demonstrate how skillfully they could achieve professional targets. There was also the lack of transparency in how managers dealt with subordinates who were found to have committed the existed malpractice. There was a clear lack of professional management within the organization (Tibman 23), and the analysis helped to understand that this company was not properly protected from numerous outside and inside factors.
Genesis of Credit Crunch at Lehman Brothers
Before the company became bankrupt, it had a record loss of 4.8 billion US dollars for the year ended May 2008. This amount of loss was contributed by a drastic fall of revenues for principal transactions including earnings from financial instruments and other assets owned by the company (Copeland 45).
The downward shift in transactions can be explained by unrealized losses of US dollars 1.6 in the year 2008 with unrealized gains of 200 million US dollars in 2007 (Copeland 78). Such changes made the Lehman managers think that their earnings were enlarged, and the general situation of the company is good indeed; this is why, they failed to notice in time how terrible their situation actually was.
Cardinal point worth noting is the reduction in value of assets which are usually appeared in some financial institutions after using the fair value accounting. Any kind of change of values leads to severe contractions of capital ratios as a result of which it is necessary to force the financial institution in order to sell its assets at a distressed price (Copeland 30).
In case the values and changes are analyzed properly, it is possible to define the threats of decline. The application of fair value accounting sends a message that a company’s solvency is deeply undermined by strategies in financial institutions or rather their practices of lending and depositing fund but it is the duty of the regulators to specify the information to use when deciding on the market prices.
In accounting, the term ‘fair value’ introduces a kind of unbiased estimate with the help of which potential market prices may be evaluated. Critics argue that fair value accounting values distracts attention from the main issue. The main concern is the quality of the associated disclosure. Former governor of Federal Reserve Bank held that the main focus should be on disclosure so that investors and other beneficiaries of financial statement comprehend the drivers behind fair values (Copeland 34).
The evaluation of the company’s fair value was not successful because poor attention was paid to the risk credit that Suisse and Lehman Brothers could face. AIG faced adverse risk because of exposure to credit evasion swaps. If the balance sheet of the mentioned financial institution is evaluated before the crisis, it would have been difficult to investigate the amount of losses following the risks. From this discussion it can be concluded that fair value accounting is not a good mirror image of value that is at risk.
Role of Fair Value
Fair value in accounting is the price value an entity would make if it were to sell assets or rather the amount paid to settle liabilities in a business entity. From the definition of Generally Accepted Accounting Principle, fair value is the amount at which an asset or a liability can be sold or bought in a current transaction.
This is possible only if the transaction is done between willing parties. The best approach for fair values is use of prices quoted in the market but in situation where these prices do not exist, then it calls for the use of reliable information available in the market to determine prices. It is widely recognized that companies employ the use of fair value in recording its assets and liabilities and other financial instruments.
An example of a model used in estimating fair values is the valuation model which considers data such as: economic conditions, status of the market and prices of other competing instruments. To ensure accuracy in arriving at fair values, business establishments must have a strong internal control system. The end result is a consistent and reasonable valuation process. In recognition of the fact that market conditions varies overtime, appraisal of valuation models must be done on a continuous basis.
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The federal government by the use of administrative powers conferred to them by the constitution pressured the Federal Reserve Bank to lower their lending standards to the intermediary banks (Sly 78). Such conditions made the managers pay more attention to mortgage-backed securities which are important debt obligations to represent the right claim on the current cash flows. People or rather investors went to borrow monies in order to invest in the housing finance.
A subsequent collapse of the housing sector led to reduction in value of securities. Valuation of these marketable securities was as a result of fair value system. Considering the fact that fair value requires the use of prices at the present time under a specific market condition, mortgage-backed securities were therefore undervalued. Continued employment of present market value when in real terms a market does not exist has destroyed the financial market.
The benefit attached to the use of fair value is its ability to provide information on financial assets and liabilities contrary to the historical cost approach. The chosen approach measures the company’s investments in such parameters like acquisition, training, familiarization, and experience. One of the most serious limitations due to this approach is that assets cannot be sold in case check of valuation is dependent on something.
Fair value system also provides comparability of assets bought or sold at different time period since it reflects the condition of the market at the present time. Investors are also more concerned with details of the balance sheet and other financial statements (Henri 67). For this reason, its preparation and disclosure will go along in supplementing on the information they have before a critical step of choosing an investment.
Securities and Exchange Board
Out of all this, the major organization seen to be at the center of the blame is the Securities and Exchange board which seemed to have turned a blind eye in regulating and investigating complaints that had been raised before. The major cause within the board was its Consolidated Supervised Entities program which was supposed to check and investigate on the investment’s bank liquid capability.
The program required that an investment bank preserve adequate liquid asset that can last a year (Tibman 54). In Lehman’s case the SEC did not enforce this program despite acquiring enough evidence to enforce legal action against the investment bank. Following a series of stress tests which assesses the level of liquidity, the bank failed to show how it could endure a year without unsecured funding but was allowed to operate.
The Sarbanes-Oxley Act was meant to ensure that no other melt down such as ENRON would be experienced again. The act gives mandates to company boards and accounting firms that are public in addition to transparent and full disclosure of accounting statements. The act also requires the SEC to regulate organizations and companies.
The act seemed reliant on the SEC which at the time was compromised .Commercial banks issued subprime mortgages that had the full security of investment banks such as Lehman. At the time of enacting the act, the onset of such events had not been thought about and no one had imagined that such a blow to Lehman was coming. This was because of the way Lehman was making money out of collaterized debt obligations that were in doubt. In lay mans terms the bonds offered was backed by mortgage pools.
It is out of these events that have led to the general public perception that the agencies cannot prevent future accounting fraud. Many Americans questioned do not trust the same bodies that were responsible in aiding the whole economic mess that they are now experiencing.
Currently the Sarbanes-Oxley Act has significantly improved the quality of audit. Under the conditions of the Act, the audit services are performed for a public firm and a number of non attest services are performed for the clients. Such division of services reduces the chances of false and misleading financial statements.
As the parties are involved in the preparation of financial statements, they are autonomous and specialize in the chosen sphere of life. For instance, an actuary undertakes actuarial services rather than the auditor. This greatly improves the quality of the financial statements and the information reflected on the statements.
The Act also points out the procedures to be followed and the appropriate personnel to undertake related tasks. Therefore, uniformity is upheld while the Act is impartial at the same time. Unruly conduct in preparation of financial statements carries along related punitive measures.
Therefore, auditors and other parties remain to be under a strict control and a number of guidelines stipulated. On the one hand, the country wins a lot due to the Act as it is obligatory to control the corporations and analyze their incomes. On the other hand, this Act promotes a certain dependence on many outside factors which deprive the companies of a chance to grow and the managers of a chance to earn more.
Effects of Credit Crunch
The effect of the crisis has made many financial institutions to resort to securitization process. The price of the houses which has also risen sharply has created in the minds of the lenders the perception that it is still not risky. High valued properties have been repossessed from individuals due to the loans which are unpaid. This has led to the increase in popularity of “self-certified” loans especially in the United States of America (Henri 65)
There are the banks that have begun buying securities from other banks. On the one hand, the Collateral Debt obligations could enhance the risk spread, still, on the other hand, these obligations are largely complicated and often do not reveal the bad loans. Apparently no one wants to receive bad news when things seem to be good. In fact, those people whose risks raised concerns about security were about to lose their jobs, while those people who try to mitigate risks may face a potential decline in their respective market shares (Krugman 45).
Banks consider being “high street” and involve themselves in a kind of investment, which is through trading, buying and selling risk. On the other hand, investment banks which are not satisfied with trading, that is, buying and selling of the risks have involved themselves in mortgages as well as loans which they have limited management skills/controls thus putting their operations at a more riskier position.
It is unfortunate that the use of a financial instrument to lend money and securities as well as reducing risks in the financial service industry has suddenly backfired due to the current economic crisis.
Failure of the banks to lend has trickled to the public and this has shattered many people’s confidence. As a result, the lending process has decreased while ceasing to exist in some cases. Loaners opt to get their money back due to the crashing down of assets and most investment banks have little or no deposits to fall back on. The financial institutions have been collapsing at a shockingly gradual rate (Krugman 89)
The sub-prime and the mortgages are not the reasons why there is an economic crisis affecting the financial institutions but they are only the consequences. The main reason for the economic crisis in the financial service industry the weak policies that have been adopted and implemented in the financial sector.
For example, during this period, the Federal Reserve has had negative interest rates which force the institutional investments to park money and get return. The mortgage –backed securities have become a favorite investment instrument. Housing investment companies are looking forward to replace the fees earned during the recent economic bubble. (Krugman 67)
Under the US requirements by the Federal Reserve, banks are required to have a certain percentage of the capital requirement to back up the loans that they make. Therefore many banks and the financial institutions have Mortgage-based securities assets on their books. This has made them have less capital at hand since to outset the outstanding loans. Therefore they have been forced to raise capital which in the end has raised fears concerning their solvency and this has accounted for the reason why some banks have gone under liquidation.
It has been observed that the general economy does not face liquidity crisis since the general economic output is generally up and unemployment is at an average of 7 percent worldwide. The process could soon spread to the capital market certainly (Krugman 110).
The problem has become so enormous to a point that even those banks which have huge reserves of capital have run out and therefore they have remained with no option but to approach governments in order to be bailed out. But unfortunately that is not enough to restore peoples’ confidence. Research shows that banks which are in the process of shrinking normally absorb much money from the countries reserves and the economy as they make an effort to put together their previous capital.
There have been calls for new regulation following the debacle that followed Bear Stearns and Lehman Brothers (Tibman 102). Calls for the overhaul of Regulations touching on corporate governance have been voiced by scholars and policy makers. In a country where compliance is expensive, these voices are fast becoming the voice of the majority.
A good example of how costly it is to comply is how it needs one to re-tool their IT systems and employing more executives dealing with compliance issues. There is also the increased cost of payment to audit committees (Johnasses 23).
The new regulations that are being called for can lead to a better and more transparent environment for organizations as it will be cheaper for them to audit and report to the authorities. The example of Lehman Brother Holdings show that it is possible to have high ratings, appropriate costs, and rather beneficial incomes, and still, undergo considerable challenges and financial problems which could lead to downfall.
To avoid unpleasant outcomes in huge corporations as well as in small private companies, it is very important to create controlling centers which are able to evaluate the financial situation constantly and consider the changes which come from the outside. Currency improvements or fair value accounting should be controlled thoroughly as they may prevent the managers from observing threats within a particular company.
The regulations like the Sarbanes-Oxley Act of 2002 may enhance the already existed standards and limit the activities of the companies within a short period of time, this is why the companies should be ready to take a number of steps in order to avoid losses, gain more benefits, and overcome the conditions which lead to downfall.
Copeland, Mary. Reviving the World Economy and Reforming The Financial Systems. New York: New York publishers, 2008.
Henri, Sam. Healthy banks needed for revival. California: The Sidney Morning Herald, 2009.
Johnasses, Ben. Sub-prime crisis. London: Sage, 2008.
Krugman, Peter. The Return of Depression Economics and the Crisis of 2008. New York :Norton Company Limited, 2009.
Sly, Mark. The Reasons behind Global Economic Crisis” in Macro-economics. London, Oxford Publishers, 2008.
Tibman, Joseph. The Murder of Lehman Brothers: An Insider’s Look at the Global Meltdown. London: Oxford Publishers, 2009.