Academic journal article Journal of Accountancy

The Role of Fair Value Accounting in the Subprime Mortgage Meltdown

Academic journal article Journal of Accountancy

The Role of Fair Value Accounting in the Subprime Mortgage Meltdown

Article excerpt

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As the credit markets froze and stocks gyrated, investors and pundits naturally looked for someone, or some thing, to blame. Fair value accounting quickly emerged as an oft-cited problem. But is fair value really a cause of the crisis, or is it just a scapegoat? And might it have prevented an even worse calamity? On the following pages, the JofA presents three views on the debate.

Both Sides Make Good Points

by Michael R. Young

How often do we get to have a raging national debate on an accounting standard? Well, we're in one now.

And while the standard at issue--FASB Statement no. 157, Fair Value Measurements--is fairly new, the underlying substance of the debate goes back for decades: Is it best to record assets at their cost or at their fair (meaning market) value? It is an issue that goes to the very heart of accountancy and stirs passions like few others in financial reporting. There are probably two reasons for this. First, each side of the debate has excellent points to make. Second, each side genuinely believes what it is saying.

So let's step back, take a deep breath, and think about the issue with all of the objectivity we can muster. The good news is that the events of the last several months involving subprime-related financial instruments give us an opportunity to evaluate the extent to which fair value accounting has, or has not, served the financial community. Indeed, some might point out that the experience has been all too vivid.

WHAT HAPPENED

We're all familiar with what happened. This past summer, two Bear Stearns funds ran into problems, and the result was increasing financial community uncertainty about the value of mortgage-backed financial instruments, particularly collateralized debt obligations (CDOs). As investors tried to delve into the details of the value of CDO assets and the reliability of their cash flows, the extraordinary complexity of the instruments provided a significant impediment to insight into the underlying financial data.

As a result, the markets seized. In other words, everyone got so nervous that active trading in many instruments all but stopped.

The practical significance of the market seizure was all too apparent to both owners of the instruments and newspaper readers. What was largely missed behind the scenes, though, was the accounting significance under Statement no. 157, which puts in place a "fair value hierarchy" that prioritizes the inputs to valuation techniques according to their objectivity and observability (see also "Refining Fair Value Measurement," JofA, Nov. 07, page 30). At the top of the hierarchy are "Level 1 inputs" which generally involve quoted prices in active markets. At the bottom are "Level 3 inputs" in which no active markets exist.

The accounting significance of the market seizure for subprime financial instruments was that the approach to valuation for many instruments almost overnight dropped from Level 1 to Level 3. The problem was that, because many CDOs to that point had been valued based on Level 1, established models for valuing the instruments at Level 3 were not in place. Just as all this was happening, moreover, another well-intended aspect of our financial reporting system kicked in: the desire to report fast-breaking financial developments to investors quickly.

To those unfamiliar with the underlying accounting literature, the result must have looked like something between pandemonium and chaos. They watched as some of the most prestigious financial organizations in the world announced dramatic write-downs, followed by equally dramatic write-downs thereafter. Stock market volatility returned with a vengeance. Financial institutions needed to raise more capital. And many investors watched with horror as the value of both their homes and stock portfolios seemed to move in parallel in the wrong direction. …

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