Irresponsible subprime lending by financial institutions, credit default swaps, and highly levered players contributed to the largest crisis to the financial system since the Great Depression. Confidence in banks and other financial service companies collapsed, and many citizens experienced detrimental losses. Was an accounting measure partly to blame?


One aspect from the financial crisis that gets less recognition was accounting standards during the period, but mark-to-market accounting policies may have intensified the financial crisis.

Accounting, though not as well recognized as it should, can carry a mighty impact on market-to-market dealings. From Kelly Sikkema on Unsplash

It is important to realize that a debate of how distressed assets should be valued can only begin with the bank’s flawed financial instruments and poor lending practices and not accounting standards. There may, however, be sufficient merit to say that had it had a worsening effect. What began with irresponsibility may have been exacerbated by mark-to-market or fair value accounting.

Fair value, as defined by the FASB, is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measured date. This standard seeks to provide a reasonable assessment of an institution’s assets and liabilities at a given time. The purpose was to provide a more accurate estimate rather than just recording these items at historical cost. Instead, this method intends to reflect the current market value and provide interested parties with accurate figures to make investment decisions.

Accounting Scandals such as Bre Ex and Enron have shaken the trust between consumers and financial firms. From Pexels

The alternative is historic cost. This had institutions recording assets at the original cost that was paid when they were acquired. After accounting scandals of Enron and WorldCom around 2002, financial institutions in America could not risk recording their assets at anything other than the “true” value. Fair value or mark-to-market became the unofficial standard leading up the crisis, then it was mandated in late 2007.

Stephen Schwartzman, co-founder and CEO of Blackstone recently explored this issue. He points out that having balance sheet items tied to the market price creates volatility in times of large price fluctuations, as was the case during the financial crisis. When markets become illiquid, mark-to-market accounting is misleading.

JP Morgan reported a quarterly loss of $7 billion dollars in 2008 partly from portfolios of subprime mortgages. The default rate on these mortgages was only around 10% but the market for mortgage-related securities was immobile. The vast majority of these debts were still being serviced, but all these securities had dropped below their true value. Given mark-to-market accounting, instead of weathering the storm of the crash and allowing for the recovery of market prices, banks like JP Morgan were forced to report huge losses. Reporting these market fluctuations every quarter instead of having a long-term outlook, as should be applied to these financial instruments, these markdowns created further panic and eroded all confidence in the banks.

A spiralling effect from bad accounting practices can lead to large scale negative effects on the global markets. From by Super Kuncheek from Pexels

Steve Forbes, chairman of Forbes Media agrees that fair value accounting was a significant contributing factor to the crisis. Writing down bad investment reduces the capital of the bank and given regulation on capital requirements, negatively decreases the amount banks are able to loan. From Victoria Krivogorsky, less capital in the system contributes to unemployment and leads to further credit defaults. In other words, accounting for defaults using fair value leads to further defaults.

An immediate critique of Steve Forbes’s position would be his assessment seems to gloss over the underlying bad investment that had to be accounted for. Many people defend fair value accounting. Lisa Koonce of the University of Texas says mark-to-market is only “communicating the effects of such bad decisions as granting subprime loans and writing credit default swaps”.

It should also be mentioned that if a bank holds the asset long enough for the market prices to recover, the loss is treated as temporary, and the effect of fair market value is effectively reversed. But during those market drops like the crisis of 2008, when the emphasis should be placed on stability, the financial sector looks more volatile than is completely accurate.

Robert C. Pozen, former president of Fidelity Investments suggests a combination of fair and historic accounting as a possible solution. Part of his solution would require banks to fully disclose the results of bad investments using fair value, but not reduce their capital requirements to the full amount. Instead of recognizing the fair value of the balance sheet this alternative could simply have disclosure in the notes to the financial statements. This allows investors to understand the full extent of the risk facing the bank and determine if these institutions can, in fact, hold the assets to maturity, but not handicap the bank’s lending ability.

It would seem that some combination of both methods may combat their respective downfalls. Large institutional players served as a catalyst for the crisis, but an imperfect reflection of banks finances through accounting standards did not alleviate much of the pain when perhaps they could have.


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References:
1) FASB. “Statement of Financial Accounting Standards No. 157.” FAS 157 (as Amended), 2006
2) Krivogorsky, Victoria. Institutions and Accounting Practices after the Financial Crisis: International Perspective. Routledge Taylor & Francis Group, 2019.
3) Laux, Christian, and Christian Leuz. “Did Fair-Value Accounting Contribute to the Financial Crisis?” Journal of Economic Perspectives, vol. 24, no. 1, 2010, pp. 93–118., doi:10.1257/jep.24.1.93.
4) Pozen, Robert C. “Is It Fair to Blame Fair Value Accounting for the Financial Crisis?” Harvard Business Review, 1 Aug. 2014
5)Schwartzman, Stephen. What It Takes. Simon & Schuster, 2019.