Reply to fellow classmate discussion

I need a reply to the following discussion post. Needs to have an in-text citation and should be approximately 2 paragraphs with an open-ended question to my fellow student. This does not need a title page, and one reference is sufficient. Please make sure there is an open-ended question at the end. Supporting material: Attached Question: To prepare for this discussion, please go the case that you read for this week, “Subprime Crisis and Fair-Value Accounting,” and review it again before you answer the following: Do you agree or disagree with the arguments of critics from the â??Subprimeâ?? case that fair-value accounting contributed to and exacerbated the recent financial crisis? Should the Financial Accounting Standards Board (FASB) reconsider its move towards fair-value accounting? Need a reply to this student: Reply to Heather! I agree with the critics from the ‘Subprime’ case that fair-value accounting contributed to and exacerbated the recent financial crisis. Lower-income families being able to “obtain mortgages that had previously been unattainable” and “some loans required less documentation than was traditionally demanded” (Healy, Palepu, and Serafeim, 2009, p.3) resulted in families purchasing mortgages that they simply could not afford. Personally, I know a family that was affected by this crisis. A $300,000 mortgage was granted to a fixed income individual. The monthly payments were $3,065 per month, and the individual received $1,600 a month for social security. Because income verification wasn’t requested, the applicant disclosed making much more, allowing the mortgage to be approved, and eventually, landing in foreclosure. If the FASB does not reconsider its move toward fair-value accounting, there will still be an exception to “ignore so called ‘distress sales’ in assessing fair value” (Norris, 2009) continuing allowance for misleading figures. Norris continues, arguing, “If the banking regulators wan tto allow banks to use different rules in calculating capital–rules that would not requuire marking down assets, for example– then they can do so without depriving investors of important information.” The only reason the crisis was salvageable to some borrowers was when “President Bush announced a limited bailout of U.S. homeowners unable to pay the rising costs of their debts” , which could have been avoidable if “fair-value accounting [was not utilized] in distressed markets”(Palepu, and Serafeim, 2009, p. 9). It seems rather plain and simple, you simply cannot trust that the numbers presented in fair-value accounting are accurate. References: Healy, P. M., Palepu, K. G., & Serafeim, G. (2009, August 5). Subprime crisis and fair-value accounting. HBP No. 9-109-031. Boston, MA: Harvard Business School Publishing. Norris, F. (2009, Sep 11). Accountants misled us into crisis. New York Times, B1.
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For the exclusive use of L. FIZZELL, 2018.
9-109-031
REV: AUGUST 5, 2009
PAUL HEALY
KRISHNA PALEPU
GEORGE SERAFEIM
Subprime Crisis and Fair-Value Accounting
On September 21, 2008, the U.S. Treasury and Federal Reserve proposed acquiring $700 billion of
distressed subprime mortgages from leading financial institutions in an attempt to restore confidence
in financial markets. The governmentâ??s actions followed a turbulent week on Wall Street in which
Lehman Brothers filed for bankruptcy, Merrill Lynch agreed to be acquired by Bank of America, and
the Federal Reserve agreed to bail out troubled insurance company AIG. All three companies had
been hard hit by the subprime crisis that was devastating the U.S. financial market, and which had
caused the Federal Reserve to arrange for Bear Stearns to be acquired by J.P. Morgan and the U.S.
Treasury to bail out the mortgage giants Fannie Mae and Freddie Mac.
Under mark-to-market accounting, many financial institutions had been required to recognize
sizable losses on their subprime investments and related securities. These losses were accompanied
by dramatic stock-price declines. For the year ended September 15, Citigroupâ??s stock declined by
69%, UBSâ??s by more than 70%, and Merrill Lynchâ??s by more than 75%.1 In response to the mounting
financial losses and battered stock prices, the boards of all three firms decided to replace their CEOs
(Citigroupâ??s Charles Prince, Merrill Lynchâ??s Stanley Oâ??Neal, and UBSâ??s Peter Wuffli).2
The crisis raised important questions for financial market regulators scrambling to preserve the
system, for investors concerned about their portfolios and retirement assets, and for corporations and
individuals who found it increasingly difficult to borrow. It also raised fundamental questions about
fair-value accounting. Had the method provided early warning signals of the problems at financial
institutions, as advocates suggested? Or, as critics argued, had it exacerbated problems by requiring
firms to make unreliable estimates of paper losses caused by liquidity problems in the markets? If
fair-value accounting was part of the problem, what alternative should take its place? As advocates
and critics debated the accounting issues, the Financial Accounting Standards Board (FASB) and
Securities Exchange Commission (SEC) were under pressure to consider whether to modify the
existing rules.
1 Computations based on data from Yahoo! Finance.
2 Greg Farrell and Mindy Fetterman, â??Citiâ??s CEO Joins Others Caught in Credit Crisis,â? November 11, 2007.
________________________________________________________________________________________________________________
Professors Paul Healy and Krishna Palepu and doctoral student George Serafeim prepared this case. This case was developed from published
sources. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary
data, or illustrations of effective or ineffective management.
Copyright © 2008, 2009 President and Fellows of Harvard College. To order copies or request permission to reproduce materials, call 1-800-5457685, write Harvard Business School Publishing, Boston, MA 02163, or go to www.hbsp.harvard.edu/educators. This publication may not be
digitized, photocopied, or otherwise reproduced, posted, or transmitted, without the permission of Harvard Business School.
This document is authorized for use only by LISA FIZZELL in MBE 503 Accounting & Ethics – Introductory Coursepack-1 taught by DANIELLE FOLEY, New England College of Business from
Feb 2018 to Aug 2018.
For the exclusive use of L. FIZZELL, 2018.
109-031
Subprime Crisis and Fair-Value Accounting
The Subprime Mortgage Market
In the 1990s, banks, thrifts and new types of specialized financial institutions began lending to
U.S. borrowers whose income levels, down payments, credit history, and/or employment status did
not enable them to qualify for â??primeâ? mortgages. These â??subprimeâ? loans generated higher interest
rates and fees to lenders, in return for bearing higher default risks.3
The U.S. Department of Housing and Urban Developmentâ??s list of lenders who specialized in
â??subprimeâ? loans increased from 61 lenders in 1993 to 210 in 2005.4 Lehman Brothers, Bear Stearns,
Goldman Sachs, Merrill Lynch, and Morgan Stanley all acquired such lenders, though all but Lehman
Brothers and Bear Stearns did so only in 2006.5 Many mortgage lenders relied on mortgage brokers to
originate mortgage loans, in return for commissions.
Federal Reserve studies estimated that the share of subprime mortgages to total originations grew
from 5% ($35 billion) in 1994, to 9% in 1996, 13% ($160 billion) in 1999, and 20% ($600 billion) in 2006.6
Exhibit 1 shows that the volume of U.S. subprime loans originated tripled from roughly 1 million in
2002 to 3 million in 2005 and 2006. Almost half of these loans arose for the purchase of a new home.
The Federal Reserve also reported that the average interest-rate difference between subprime and
prime mortgages declined from 2.8% in 2001 to 1.3% in 2007.7
One of the largest subprime lenders was Countrywide Financial. In 2003, Fortune magazine
described Countrywide as the 23,000% stock, referring to the stock return it generated from 1982 to
2003, exceeding that of Washington Mutual, Wal-Mart, and Warren Buffett’s Berkshire Hathaway.8
Contrary to prior standard practice, Countrywide did not offer the same interest rate to all borrowers.
The company based customer rates on automated statistical models that predicted the likelihood of
default on the basis of borrower characteristics. These were introduced to make it easy for mortgage
originators to know whether their loans would be acceptable to Freddie Mac and Fannie Mae,9
though their use expanded well beyond this purpose. One variable that played a key role in these
models was the borrowerâ??s credit score. While there were several approved commercial credit score
formulas (regulators did not allow scores to depend on race, gender, marital status, or national
origin), the most popular was the FICO score invented by the Fair Isaac Corporation. Studies by
Freddie Mac had shown a strong correlation between FICO scores and defaults on mortgages in the
pre-1995 period.10
The subprime boom provided attractive opportunities for lower-income borrowers. Given the
rapid growth in U.S. housing prices during the 1990s and early 2000s (see Exhibit 2), borrowers were
able to refinance their existing mortgages with new mortgages that had higher principal values.
3 The review of the subprime markets was based on information provided in â??Subprime Meltdown: American Housing and Global Financial
Turmoil,� by Julio Rotemberg, Harvard Business School Case 9-708-042, January 2008.
4 www.huduser.org/datasets/manu.html.
5 Rotemberg, ibid.
6 Ben Bernanke, â??Fostering Sustainable Homeownership,â? Federal Reserve Board, March 14, 2008.
7 Bernanke, ibid.
8 Shawn Tully, â??Meet The 23,000% Stock: For 20 years, Countrywide Financial has been on a tear. With the housing boom
winding down, can this mortgage star keep from falling?� Fortune, September 15, 2003.
9 Freddie Mac and Fannie Mae were government-sponsored enterprises (GSEs) that bought qualifying or â??conformingâ? loans
from mortgage originators, repackaged them, and sold them on the secondary mortgage market with a guarantee that the
interest and principal would be paid regardless of whether the borrower actually repaid the loan. Their role was therefore to
provide liquidity to the U.S. home mortgage market.
10 See Rotemberg, ibid.
2
This document is authorized for use only by LISA FIZZELL in MBE 503 Accounting & Ethics – Introductory Coursepack-1 taught by DANIELLE FOLEY, New England College of Business from
Feb 2018 to Aug 2018.
For the exclusive use of L. FIZZELL, 2018.
Subprime Crisis and Fair-Value Accounting
109-031
These borrowers received the difference between the new and former loan amounts (net of fees) in
cash, enabling them to effectively use some of their home appreciation to support personal spending.
The subprime boom also enabled lower-income families to obtain mortgages that had previously
been unattainable. Some loans required less documentation than was traditionally demanded.
Instead of requiring proof of income or independent appraisals of the value of the home, these
subprime mortgages were based only on â??stated incomeâ? or â??stated value,â? which was convenient
for borrowers who had casual jobs that were difficult to document. To avoid the need to put any
money down, brokers could offer a second, â??piggybackâ? mortgage that covered the down payment
on the first. In addition, many of these borrowers were offered mortgages with easy initial terms in
the expectation that as future housing prices rose they would be able to refinance at favorable new
terms.11
Secondary Markets for Mortgage Securities
Mortgage lenders financed subprime mortgages through a burgeoning secondary mortgage
market. Investment banks securitized lender mortgage receivables and sold them to third parties as
mortgage-backed securities (MBS). MBS were pools of mortgages that entitled investors to a share of
the principal and interest payments (net of a service fee earned by the servicing firm, typically the
loan originator). Mortgage pools comprised mortgages with particular interest rate, maturity, and
property characteristics.
In the early 2000s, MBS issues exploded (see Exhibit 3), with the leading issuers Countrywide
Financial and many Wall Street firms. Among the largest issuers in 2005 and 2006 were Countrywide
Financial, Lehman Brothers, and Bear Stearns.12 MBSs were typically sold to collateralized mortgage
obligations (CMOs) and collateralized debt obligations (CDOs). A CMO was a special-purpose entity
(SPE) created to acquire and hold MBS assets. The SPE issued different classes of bonds and equity,
with differing priorities on the entityâ??s cash flows; senior notes were paid before junior notes and
equity notes. Thus, lower classes of debt and equity holders bore more of the default and prepayment
risks associated with the underlying mortgage receivables. A CDO was similar to a CMO, except that
the SPE acquired other assets, such as securitized credit card receivables, in addition to MBS
receivables. Banks that sponsored CMOs or CDOs earned attractive commissions at issue, as well as
management and service fees during the CMO or CDO lives.
Rating agencies played an important role in the secondary mortgage market. Agencies such as
Standard & Poorâ??s, Moodyâ??s, and Fitch rated the MBSs themselves as well as the bonds issued by
CMOs/CDOs. The rating agencies awarded higher ratings to CMO/CDO bonds that had higher
priority in the distribution of funds. The formulas allocating payments to bonds were complex. For
example, the share of principal (but not interest) payments going to a particular bond could depend
on whether realized losses exceeded a threshold by a particular date. Senior tranches of CMOs/CDOs
holding MBSs received high ratings because statistical models determined them to be safe. However,
according to a Lehman Brothers report, in 2007 CMOs and CDOs held a substantial fraction of
subordinate MBS securities (those rated below AAA).13
While some CMOs/CDOs used long-term debt to fund the acquisition of MBS assets, many
banking institutions raised funds in the short-term commercial paper market. Rating agencies
11 See Rotemberg, ibid.
12 See Asset-Backed Alert Worldwide Update of Asset Securitization (www.abalert.com/Public/MarketPlace/Ranking/).
13 Vikas Shipiekandula and Olga Gorodetsky, â??Who Owns Residential Risk?,â? Lehman Brothers, September 7, 2007.
3
This document is authorized for use only by LISA FIZZELL in MBE 503 Accounting & Ethics – Introductory Coursepack-1 taught by DANIELLE FOLEY, New England College of Business from
Feb 2018 to Aug 2018.
For the exclusive use of L. FIZZELL, 2018.
109-031
Subprime Crisis and Fair-Value Accounting
provided high ratings for CMO/CDO debt based on lines of credit from the sponsoring institution.
Such lines of credit assured the purchasers of the CMOâ??s/CDOâ??s commercial paper that the
CMO/CDO would not have to sell its assets in a â??fire saleâ? if the commercial paper market suddenly
dried up. Citibank pioneered a related structure, called a SIV (structured investment vehicle). SIVs
also relied on commercial paper with high ratings. However, their sponsoring bankâ??s line of credit
was smaller and outside investors were brought in to take an equity position. As a result, regulators
allowed sponsoring banks to keep SIVs off their balance sheets.
Loans that met certain size and credit criteria could be insured against default risks by any of the
government-sponsored enterprises (GSEs), such as Freddie Mac, Fannie Mae, or Ginnie Mae.14 GSEguaranteed loans (or â??agency loansâ?) protected CMOs/CDOs from credit risk but not interest-rate
risk. Loans not conforming to the GSE standards, or â??nonagencyâ? loans, were subject to both credit
risk and interest-rate risk. A breakdown of agency and nonagency loans from 1996 to May 2008 is
shown in Exhibit 4. Issuers of CMOs/CDOs with nonagency loans generally structured their deals to
reduce the credit risk for â??senior bondsâ? using some form of credit protection. The most widely used
protection was credit default swaps (CDS). Under these contracts, the CMO/CDO â??buyerâ? made
periodic payments to the â??sellerâ? in exchange for the right to a payoff if there was a default on the
mortgage receivable. A credit default swap therefore resembled an insurance policy because it could
be used by the buyer to insure against a default. However, credit default swaps could also be used for
speculative purposes and were not generally considered insurance for regulatory purposes. CDO
sellers included Merrill Lynch, Citigroup, AIG, UBS AG, Deutsche Bank AG, as well as bond insurers
Ambac Financial Group Inc. and MBIA Inc.15
In January 2006, Markit and a consortium of investment banks launched a set of indices called
ABX-HE (HE stands for home equity). These indices tracked the price of over-the-counter credit
default swaps. Issuers of these contracts agreed to receive a stream of fixed payments in exchange for
making â??floatingâ? payments that would increase whenever Markit determined that borrowers had
fallen behind on the mortgages held by the MBS or that a MBS write-down was warranted.16 The
standardization provided by these indices increased transparency in the subprime market, with
different ABX-HE indices tracking MBSs of different ratings and providing a benchmark for financial
institutions on the market value of their assets.
Falling Housing Prices and the Rise in Foreclosures
After a decade of U.S. housing price increases, in late 2006 prices began to fall. The decline
continued through 2007, leading to the first year-over-year decline in nationwide house prices since
1991. As shown in Exhibit 5, by September 2008 prices had declined by 19% relative to their peak.
The declines were most pronounced in Florida, southern California, and Nevada. The fall in housing
prices was accompanied by an increase in short-term interest rates that triggered increased payments
14 Of the total U.S. residential mortgage debt of $11 trillion at the end of 2006, outstanding MBSs of the GSEs was $2.5 trillion.
The GSEs claimed to be relatively immune to credit risk because they required private mortgage insurance for loans whose
loan to value (LTV) exceeded 80% and because their private-label MBSs were highly rated by credit-rating agencies. Privatelabel MBSs were obligations of specially created trusts that held ultimate title to packages of mortgages and who distributed
the interest, principal, and other payments of the borrowers to different classes (or â??tranchesâ?) of bonds according to
prespecified priority formulas.
15
â??Bank CDO Losses May Reach $77 Billion, JPMorgan Saysâ? (Update1), by Jody Shenn, Bloomberg.com, Nov. 27, 2007.
16 If write-downs were later reversed, the firm making â??fixedâ? payments was expected to raise its payments to the other party.
4
This document is authorized for use only by LISA FIZZELL in MBE 503 Accounting & Ethics – Introductory Coursepack-1 taught by DANIELLE FOLEY, New England College of Business from
Feb 2018 to Aug 2018.
For the exclusive use of L. FIZZELL, 2018.
Subprime Crisis and Fair-Value Accounting
109-031
for many subprime lenders. The two events resulted in a dramatic increase in delinquencies.17 As
shown in Exhibit 6, delinquency rates for single-family residential mortgages tripled from 1.4% in the
first quarter of 2005 to 4.3% by the second quarter of 2008.
In December 2007, the Mortgage Bankers Association (MBA) announced that 6.89% of subprime
loans were in foreclosure in the third quarter of 2007, compared to only 0.79% for prime loans.18 A
Federal Reserve Bank of Boston study published at the same time concluded that about 20% of loans
that were originally financed with subprime mortgages would ultimately foreclose.19 Observing that
foreclosures were more common in neighborhoods where house prices had fallen more, the study
predicted even more foreclosures in cities such as Los Angeles and Miami, where prices had fallen
from their peaks by 29% and 30%, respectively (Exhibit 5). In mid-2008, Pew Charitable Trusts
predicted that 1 in 33 U.S. homeowners could be headed toward foreclosure due to the subprime
crisis and that, as a result, 40 million homeowners could see their property values and their
municipalitiesâ?? tax bases drop by as much as $356 billion in the next two years.20
Impact on Financial Institutions
The plunge in residential property values in 2007, the steepest since 1989, and a surge in
foreclosure activity caused the value of subprime mortgage securities to collapse. Exhibit 7 shows the
ABX-HE 07-1 index for residential MBS from February 2007 to the end of October 2008. During this
period, the ABX-HE-AAA 07-1 index fell from 100 to 40 and the ABX-HE-A 07-1 index fell from 100
to 5. These values implied that in February 2007, when the AAA index was valued at par, an investor
seeking to insure $10 million of AAA-rated MBS would make annual coupon payments (of roughly
0.11% of the loan value, or $11,000) for the life of the loan. But if the same investor purchased
insurance in October 2008, the cost would include not only the annual coupons but 60% of the loan
value ((100% – 40%) Ã? $10 million, or $6 million).
The decline in value of subprime securities created problems for the commerical paper market. As
shown in Exhibit 8, outstanding asset-backed commercial paper declined by more than 40%
beginning in fall 2007. This cut off funding for many of the SPEs that had financed acquisitions of
MBS with commercial paper and increased the exposure of issuer financial institutions that had
guaranteed the loans.
The U.S. Treasury secretary, Hank Paulson, called the housing market collapse â??the most
significant risk to our economy.� In February and March of 2007, more than 25 subprime lenders
declared bankruptcy, announced significant losses, or put themselves up for sale.21 On April 2, 2007,
New Century Financial, the largest U.S. subprime lender, filed for Chapter 11 bankruptcy.
In August 2007, subprime mortgageâ??backed securities were discovered in portfolios of banks and
hedge funds around the world, leading to further failures. American Home Mortgage Investment
Corporation (AHMI) and Ameriquest (once the largest U.S. subprime lender) both filed for
17 When a borrower became delinquent for a prespecified period of time, the lender could initiate foreclosure proceedings.
Unless the borrower made sufficient payments to become current (including fees for late payments) or the borrower reached
an agreement with the lender, an official foreclosure auctio …
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