The Role of Accounting in the Financial Crisis

Posted by R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Friday March 2, 2012 at 9:36 am
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Editor’s Note: The following post comes to us from S.P. Kothari and Rebecca Lester, both of the Department of Economics, Finance, and Accounting at MIT.

In our paper, The Role of Accounting in the Financial Crisis: Lessons for the Future, which was recently made publicly available on SSRN, we discuss the causes of the financial crisis, with particular focus on the debated role of the relevant U.S. accounting standards, and summarize implications for accountants and accounting regulators based on the effect of these existing rules.

The Great Recession that started in 2008 has had significant effects on the US and global economy; estimates of the amount of US wealth lost are approximately $14 trillion (Luhby 2009). Various causes of the financial crisis have been cited, including lax regulation over mortgage lending, a growing housing bubble, the rise of derivatives instruments such as collateralized debt obligations, and questionable banking practices. In addition to these and many other reasons, we explain two factors that partially contributed to the crisis: certain management incentives and fair value accounting standards.

Following the dot-com bubble in 2000 and the September 11, 2001 attacks, the U.S. economic policies of low interest rates coupled with easy credit, lower taxes, and the cheap dollar generated significant economic growth from 2000 to 2007. Low interest rates motivated many in the United States to pursue home ownership, a goal long propagated and encouraged by the government as a wise investment and worthy social objective. Easy credit facilitated by agencies such as Fannie Mae and Freddie Mac enabled financial institutions to focus on the lucrative subprime mortgage market. Mortgage lenders initiated a growing number of new home loans, many of which were granted to individuals with a poor credit rating, who would eventually be unable to service monthly mortgage payments once interest rates increased. Unfortunately, gains generated from securitization of the home loans and from income on the servicing of the loans inflated financial profits, motivating executives of mortgage origination firms to focus on quantity, rather than quality, of borrowers. Investors, seeking new investment opportunities, fueled the demand for mortgage backed securities that were created through securitization of the home loans. Such securities received high ratings from analysts who also did not correctly assess the underlying default risk.

In early 2005, interest rates began to rise, increasing up to 8.25% in 2007 from 4% in 2004. In response, a large number of homeowners, particularly those with adjustable rate mortgages, began to default on their monthly payments. In 2007, New Century Financial, the second largest subprime mortgage originator in the US, announced a restatement of its financial statements for the first three quarters of 2006 due to under-reserving certain loan loss provisions. This announcement was followed shortly thereafter by large losses for firms with significant subprime positions, including Bear Stearns, Lehman Brothers, Merrill Lynch, and Citigroup. The market (using the Dow Jones Industrial as a benchmark) dropped precipitously from over 14,000 points in October 2007 to under 7,000 in March 2009, with a drop of almost 2,000 points in one week alone in September 2008. The subprime mortgage woes resulted in a significant and prolonged recession.

The companies engaged in the subprime mortgage business, including both originators/securitizers of loans and purchasers/investors in the securitized instruments, were able to report certain gains on securitization of loans under U.S. accounting standards. Furthermore, companies followed U.S. accounting standards to record loan servicing assets and residual interest assets, as well as certain loan loss reserves, using historical prime mortgage performance to estimate the appropriate value. Finally, purchasers/investors of the securitized instruments accounted for securities under the fair value accounting rules, which permitted the firms to mark (or not mark) certain assets up to fair market value, as measured based on classification of the instrument.

While the actual fair value standards themselves may not have been the culprit behind the financial crisis, we believe that the inconsistent implementation and subsequent misapplication of the standards contributed in three ways to the financial crisis. Specifically, reporting of immediate gains on securitization facilitated and motivated more subprime lending. Second, some amounts originally selected as Level 1 and Level 2 fair values were incorrect, but once borrowers began to default on home loans, firms switched to Level 3 internal estimates rather than adjusting to the true declining fair value. The ability to use these internal estimates enabled firms to continue to assume risk. Finally, the eventual recognition of losses and the ripple effects through the economy resulted in a large, rapid decrease in the amount of banks’ capital. For these reasons, we believe that the misapplication of the U.S. accounting standards had some role in the financial crisis.

The full paper is available for download here.

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