Accounting and the Credit Crisis of 2007/2008
Part II: Why It All Went Wrong
On January 30, 2008 the anger and suspicion exploding from the credit crisis with its billions of dollars of investor and homeowner losses had reached the point that the Wall Street Journal reported that the Federal Bureau of Investigation was opening criminal inquiries into 14 companies as part of a broad investigation. At the same time, the Securities and Exchange Commission had begun investigations into sub-prime mortgage and securitization issues at various large financial companies such as Bear Stearns, New Century Financial, Morgan Stanley, and Goldman Sachs Group. As well, by January 2008 scores of lawsuits including shareholder class action, fiduciary, and malpractice suits had been filed against many financial companies. In March 2008 the spectacular collapse and emergency sale of 85-year old Bear Stearns to JP Morgan created a new financial shockwave around the world. The credit crisis had clearly escalated to a dangerous magnitude, and now thousands of injured parties were trying to figure out what went wrong and were looking for someone to blame.
Here, we will examine the key events and the players in these events. Then we can begin to piece together what went wrong. The events involved the participation of all the following actors: The Federal Reserve Bank, banks as mortgage lenders, investment companies buying and securitizing loans, rating companies, the application of generally accepted accounting principles, and investors who wanted ample, easy, and safe profits.
The Federal Reserve Bank
In the United States, the Federal Reserve System (the “Fed”) is a central national bank that has the ability to control the money supply and change important interest rates. In response to an economic slowdown in 2001, the Fed greatly lowered interest rates over a period of about 2 years. However, these lower interest rates over-stimulated the economy, especially the housing market, which began to see record sales and price increases. Worried about inflation, the Fed then reversed monetary policy in 2004 and over a period of several years began to significantly raise interest rates, making loans more expensive and in particular making the payments higher on adjustable rate mortgages, which many home buyers had used to purchase their homes. Because of the continued rapid rise in rates, many buyers could no longer afford their home loan payments and eventually stopped paying.
The Transaction Process: Mortgage Lenders and Investment Companies
Step 1: Making Loans
When a bank or other lender loans money to a home buyer, the lender’s cash decreases and is replaced by a different asset, which is a long-term receivable (a note receivable) that is of equal value. Historically, a lender has had two choices at this point: 1. Keep the note and collect the principal and interest payments from the borrower over the term of the note, or 2. If the note is secured by a sufficiently high value property and the borrower is very credit-worthy, the note could be sold to federal government sponsored mortgage buying agencies (such as the Federal National Mortgage Association: “Fannie Mae”). Selling the note replaces the cash and usually records a profit for the lender bank. With the new cash, the lender can then continue making more loans and also satisfy the bank capital requirements imposed by government regulations.
During the early 2000s real estate values continued to increase, and lenders saw a great opportunity: There were many more, but less-qualified, homebuyers who were still eager to purchase homes and would pay higher interest rates and fees than on more secure loans. To accommodate these marginal buyers, lenders reduced their lending standards. By October 2007, a Senate joint economic committee estimated that almost a trillion dollars of outstanding lower-quality (“sub-prime”) loans had been made, many of these adjustable rate loans. In turn, all this loan money available to buyers increased home sales and pushed real estate prices even higher, making lenders believe that the loans were secured by more than enough property value, even if financially problematic buyers might have trouble making their loan payments.
Step 2: Transfer and Securitization
Because the sub-prime loans were of much lower quality, the lenders had a potential problem. The resulting new notes receivable could not be sold to government agencies. To solve this, the lenders did some creative financial thinking and utilized another alternative. The lenders sold the notes to large investment companies who paid the banks cash for the notes. In turn, the investment companies created other companies designed especially to purchase the notes from the investment companies. These special companies are called “structured investment vehicles” or “SIVs” and the process is often called “structured financing”.
However, when the SIVs acquired the notes or note-backed securities, they borrowed extremely heavily — in some cases, up to $30 of debt for every dollar invested in the notes by the SIV. The ultimate effect of this borrowing would be to greatly magnify the size, power, and speed of potential losses.
The SIVs kept the notes and “securitized” them. This means that the SIVs created securities that investors would pay for. The SIVs used the cash from the investors to pay the investment companies for the notes. Then, as long as the notes continued to receive the principle and interest payments from the borrowers, this cash could be passed along to the investors (with a little taken as profit for the SIVs and investment companies). Most often, the securities that the SIVs created were short-term notes payable called “asset backed commercial paper” (a common type is a “CDO” - collateralized debt obligation). In effect, when investors purchased this commercial paper, they were accepting the risks associated with the risky loans that were security for the commercial paper. In many cases, the investment companies and SIVs offered various kinds of explicit and implicit assurances to the investors. Basically, the events looked like this:
Why All the Steps?
- The bank needs to sell the notes to obtain cash and remove the risky notes from its balance sheet. This makes the balance sheet look better and renews the cash balance. The bank also records a profit when the note is sold.
- The investment company knows how to create and sell securities to investors. Like the bank, the investment company wants to remove the low-quality notes from its balance sheet. Also the investment company records a profit from the SIV when the securities are sold to investors.
- SIVs are used because the investment company needs a business that it can control and at the same time that will purchase the notes and keep them off of the balance sheet of the investment company.
The Accounting Issues
Issue #1: The Entity Principle
One of the first basic accounting principles taught to students is the “entity principle”. This principle states that it is necessary to identify the particular organization or economic unit (the “entity”) for which the accounting is to be performed. If an entity cannot be identified, accounting becomes meaningless. (It becomes impossible to apply the accounting equation - see Part I.) Very detailed and complex accounting rules require that any business that creates another business must relinquish all effective control over the new business in order to recognize the two entities as separate; in other words, separate accounting equations for each economic unit. “Control” is not only direct control such as voting, but also indirect economic influence such as guarantees or implicit obligations to support the new company.
However, investment companies almost always exercise direct or indirect control over SIVs. So, on which set of books should the SIV transactions have been recorded? Should there be just one accounting equation for the combined activities? It was clear that those companies that had provided explicit guarantees to SIVs had direct influence, so many of these investment companies had to keep the notes on their own books and record all the investment losses on their own books. However, some large investment companies provided only implicit assurances, which were never fully clarified. Some of these large companies, to save their reputations, eventually agreed that the SIVs were not really separate companies and the companies then recorded the SIV transactions on their own books and absorbed the SIV losses.
Previously unrecorded and undisclosed obligations to repay the SIV investors suddenly appeared on the balance sheets of the investment companies. Because of the arcane complexity of the accounting rules, most investment company stockholders had no idea that this potential liability existed, or how it could happen. These surprise actions became the objects of numerous lawsuits.
Issue #2: Classification
Classification is an essential dimension in accounting (classification, valuation, and timing). When a transaction is recorded, all parts of the transaction must be correctly classified in the accounting equation by type of asset, liability, and owner’s equity item. With the creation of the SIVs, in some cases the misclassification went far beyond the need to correctly classify a particular item in the accounting equation - assets and liabilities were classified as part of the wrong business entity! (Because in many cases the SIV transactions should have been on the books of the investment companies all along.)
Issue #3: Valuation
Valuation is one of the most deeply divisive issues in accounting. Although numerous accounting valuation rules are in place, there remains widespread professional controversy concerning their efficacy and consequences. What the general public does not often appreciate is that value, whatever method is used, is subjective. Except for cash, an asset’s value is never exactly known until it is converted into cash (sold) or discarded (zero value). Some non-cash asset values can be more reliably determined than others, but the essential point remains.
In general, accounting has been evolving toward what is called current “fair value”. This sounds good, but often “fair value” can be difficult to determine. This is particularly true for complex financial assets that do not trade in active, deep markets. For these assets accounting rules require management to estimate value using complex formulas that require numerous, often subjective, assumptions such as estimated risk or probable future cash flow. These assumptions can easily change as financial conditions wax and wane and market conditions change. The result is that changes in value of complex financial assets can move unpredictably between extremes. As well, keep in mind that valuation changes result in “paper” gains and losses - the assets are not being sold - no cash is involved. (This is cold comfort to the investor who watches the stock price evaporate as valuation losses are reported.) However, fair value certainly does provide financial statement users with one significant benefit - a healthy appreciation that asset wealth can and does decrease (or increase) unpredictably, long before the assets are sold.
Issue #4: Full Disclosure
The full disclosure principle requires that all information that could make a difference in the decisions of financial statement users must be fully and clearly disclosed in the financial statements or the footnotes to the statements. Full disclosure (“visibility”) is particularly important for large and complex items in the financial statements, such as the note assets in the SIVs and the nature of the SIVs themselves. However, due to the complexity and subjectivity of calculations and aggregation of large amounts of different loans, disclosure in many cases was of only marginal help - visibility was limited. Finally, the most detailed disclosures occur at only annual intervals, far too late.
The Rating Companies
Ok, so if we are not accounting experts, can we find people who are? For many years, investors have relied on professional rating companies such as Moodys, Standard and Poors, and Fitch that rate the quality of a company’s securities. In principle, these rating companies are the “experts” who can scrutinize a company’s operations and financial statements and then provide both an expert and an unbiased opinion to guide investors. However, various financial experts are now saying that some rating companies compromised their work in numerous ways, including a lack of independence. Because the rating companies are often paid by the companies that they are rating, there exists the potential for an inherent conflict of interest. It has been asserted that potential clients unhappy with a proposed rating have been able to obtain a change in the person doing the rating work or shop around for a different rating company, but the facts are still unclear. Finally, as this is written, the Federal Justice Department has also begun an investigation into whether one of the rating companies threatened to use unsolicited negative ratings as a means to force companies to hire the rating service.
Putting it all together: What went wrong
Looking back, we can see that what happed was a combination of cascading elements that together created a perfect storm for disaster:
- The Federal Reserve System made money easily available, then changed its mind and raised interest rates, first creating a boom in the real estate market and then trapping financially fragile home buyers unable to make loan payments and unable to sell their homes in a suddenly declining market.
- In order to make more money, many mortgage lenders had lowered their lending standards to attract less qualified and previously unqualified buyers.
- In order to make more money, investment companies purchased risky real estate notes from the mortgage lenders and used the loans to create very complex securities, knowing that many investors did not fully understand the nature and risk of the securities, and the complexity of the accounting rules.
- Rating companies may not have analyzed the securities with sufficient independence, rigor, and timeliness, with the result that investors could not really comprehend the quality and potential risk involved.
- The accounting rules, especially those concerning entity and valuation, are complex and subjective, requiring the use of numerous assumptions. The valuation rules required reporting of large and unexpected, but unrealized losses.
- Investors did not fully understand either the nature of the investment or the meaning of the complex financial statements related to the investments, yet ignored this lack of understanding.
- The heavy borrowing (called “leverage”) by the SIVs hugely magnified the size, speed, and scope of the losses, because as the notes lost value the lenders to the SIVs and investment companies demanded immediate cash to cover the value losses, which either drained cash from investment companies and reduced their equity capital or created the forced sales of securitized assets to obtain cash, which in turn created additional value losses and a downward spiral of more demands for cash and greatly reduced lending.
By Greg Mostyn, Mission College