Take a deep breath. The market recovered from terrorist attacks, the falls of Enron, WorldCom and Arthur Andersen, soaring oil prices and one very expensive war. Can this sub-prime crisis really hold the market back? To answer this query, the cause must be examined.
Sub-prime loans are generally offered by lenders to customers with either no credit or a poor credit history. In most cases, these loans include adjustable interest rates. During the initial years of the loan, the interest rate will be low (as compared to fixed rate loans for the same customer) and fixed, effectively lulling the payer into a false sense of security. After this initial period, the rates generally revert to the prime rate plus a specified margin. The prime rate varies directly with the Federal Funds Rate set by the Federal Reserve. For example, for the first two years, the lender may offer the loan for 8.9 percent, and then the rate for the remaining years becomes the prime rate plus 6.5 percent. If the prime rate is 5.5 percent for year three of the loan, the payer is stung with a twelve percent interest rate.
The problem was simple, right? The sub-prime crisis was caused by banks offering customers with poor credit adjustable rate loans and mortgages that those customers would never have the ability to honor once interest rates began to rise from their basement of several years ago. As interest rates continued to rise, more borrowers defaulted on their loans. The banks seized houses and any other assets they could grab as their customers declared bankruptcy. In this scenario, the banks do not seem to be the losing party, but they are. Not only do they lose millions of dollars in interest revenue when their borrowers default, but they acquire assets that are quickly declining in value as the economy slumps. In the past, banks could hold these assets at cost until a good market for them arose. In 2007 with the addition of Financial Accounting Standards Board Rule 157, banks were required to report their assets at fair value instead of cost. Now, the banks are forced to write down the value of their assets to market prices at which they do not intend to sell the assets. These huge write-downs have cut profits drastically and sent investors packing for the next available flight. As more assets are written down, lower profits are not the only problems facing banks. These huge write-downs are proving hazardous to the banks liquidity and solvency.
Proponents of the new fair value standards would argue that writing down assets to market value gives investors a better picture of the current financial standing of the company. Is this true? American International Group (AIG) Chief Executive Officer Martin Sullivan begs to differ, saying, that companies should not be forced to write down assets which they will not sell at basement prices. This statement came after a five billion dollar mortgage related write down (Hughes 16). This is not to say that the company would not have suffered losses without the new standard, but they would have been minimized. Under previous rules, the assets would be checked for impairment. If the expected future cash flows were lower than the net book value, then the assets would be written down to market value. This system seems much more suited to handle the ups and downs of the economy. If a company plans to sell an asset during the next upswing, then the future cash flows are still the same, even if the current market value is low due to external economic factors.
As the problem grows, companies outside the financial sector are writing off huge sums. Bristol Myers Squibb wrote assets down by 275 million dollars in early February (Guerrera 17). Many more seem sure to follow as the first reporting year with FAS 157 in effect trudges forward. The question then arises, is it wrong to keep assets on the books at historical cost if there is no current market for them? If companies plan to hold these mortgage securities until maturity, then why should they be forced to revalue them at current market price? There is no way to make an accounting system perfect. There are, of course, faults with the old system of booking at historical cost and testing for impairment periodically, but these old faults did not exacerbate an already volatile situation sending the economy into a recession. FAS 157, if nothing else, was poorly timed. The Financial Accounting Standards Board should have had the foresight to delay FAS 157 until the economy worked through the sub-prime mess. If they had waited one year, the economy could have recovered and the banks could have begun to unload some of their mortgage securities over time in order to soften the blow.
In accounting since Enron and WorldCom, it is undeniably important to keep companies honest in their reporting, and seemingly, that is the intent of FAS 157, but to some extent FASB should ask itself; at what cost do we regulate proactively? Does perfectly accurate information for investors trump the value of the jobs that will be lost as bankers slash costs to cover losses?
CFO.com. FAS 157 Could Cause Huge Write-Downs. Retrieved March 15, 2008, from CFO.com
Guerrera, F. & Hughes, J. (2008, February 7). Effects of Credit Crisis Spreading Says PwC Chief. Financial Times (London), p. 17.
Hughes, J. & Tett, G. (2008, March 14). An Unforgiving Eye Bankers Cry Foul Over Fair Value Accounting. Financial Times (London), p. 15.
Hughes, J. (2008, February 14). Concept of ‘Fair Value’ Ignores Stench of Real World. Financial Times (London), p. 16.
Koza, H. (November 9, 2007). Thought the Subprime Mess Was Bad? Wait Till the Accountants Get Involved. The Globe and Mail (Canada), B10.
Plender, J. (2008, February 13). Financial Crisis Presents a Test for Fair Value Accounting. Financial Times (London), p. 22.
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