Fair Value Accounting and the Subprime Mortgage Crisis: Causes and Consequences

The subprime mortgage crisis was a devastating event that left many people struggling to make ends meet. This crisis was, in part, caused by the widespread adoption of fair value accounting, which led to the misvaluation of mortgage-backed securities.

Fair value accounting requires companies to estimate the value of their assets and liabilities based on current market conditions. This can be a challenge, especially in times of economic uncertainty.

The crisis was exacerbated by the fact that many mortgage-backed securities were based on subprime mortgages, which had a high likelihood of default. These securities were often packaged and sold to investors, who were not aware of the risks involved.

As a result, many financial institutions found themselves holding large amounts of worthless securities, leading to a massive loss of value and a subsequent credit crisis.

Fair value accounting is a financial concept that has been around for a while, but its importance was really driven home during the subprime mortgage crisis. The Financial Accounting Standards Board (FASB) implemented SFAS 157 in 2006 to expand disclosures about fair value measurements in financial statements.

The definition of fair value accounting is a price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. This definition is accompanied by a framework that categorizes different types of assets and liabilities into 3 levels, and their measurement varies accordingly.

The hierarchy of fair value is pretty straightforward: Level 1 assets or liabilities are those whose values can be observed on an active market, while Level 3 assets or liabilities are those whose values couldn't be quoted from an observable market but are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement.

Historical cost accounting proved inadequate for valuing derivatives, which led to the development of fair value accounting to improve information transparency and inform investors about interest and credit risks. The expanding use of derivatives in the 1980s further highlighted the need for fair value accounting.

Fair value accounting played a significant role in the subprime mortgage crisis.

Research suggests that fair value accounting contributed to the crisis, as seen in the study "Did Fair-Value Accounting Contribute to the Financial Crisis?" by Christian Laux and Christian Leuz.

The authors found that fair value accounting led to a mispricing of assets, causing banks to overvalue their holdings and take on excessive risk.

This mispricing was further exacerbated by the use of models that were not reflective of market conditions, as noted in the study "Do Investors Perceive Marking-to-Model as Marking-to-Myth? Early Evidence from FAS 157 Disclosure" by Kalin S. Kolev.

The crisis was also characterized by a lack of transparency and liquidity, which fair value accounting failed to address.

A study by Andrea Enria, Lorenzo Cappiello, and others found that fair value accounting and financial stability are closely linked, with fair value accounting potentially contributing to financial instability.

Here are some key findings from the studies mentioned above: