Fair Value Accounting

This is the second reason that led to the subprime crisis. In the processes of giving subprime loans, many errors and omissions were committed by the federal regulators. These regulatory lapses were especially committed when banks got involved in securitization, as they occurred due to the regulatory policies on the bank. The subprime markets were initially designed for the government-sponsored entity – GSE markets. The reason why there was the subprime crisis was due to the fact that the federal regulators omitted regulations and the accounting rules for the subprime mortgage loans.

The federal regulators did not ensure that they followed the rules and the regulations that were used in giving of the subprime loans. The other reason is that many rating agencies refused to make changes on the rules and regulations of the mortgage loans applications. They were so rigid in the amendment of the rules and regulations even though the rules and the regulations were not of the correct standards. The congress of the U. S. had encouraged the use of the off-balance-sheet entities for many years.

The congress also authorized the use of the over-the-counter derivatives, risk-based capital requirement and other favorable accounting rules in 1991 for the purchase, packaging as well as selling unregistered securities to many investors using the de facto assembly line that was created by Wall Street. These unregistered securities included the subprime collateralized debt obligations. The Europeans describe the subprime markets as the shadow banking systems while the U. S. claimed the market was created and has expanded due to the approval of the Greenspan and other leading banks in the EU and U.

S. The subprime market also expanded due the encouragement of the academic research community. These markets were also established due to the financial crisis that occurred in the 19th and the 20th century. After the establishment of the market, the U. S. ensured that there were legal structures and also market guidelines that were to be used in the markets. In March 2001, the Big Bang of the decimalization was unraveled since it was already under pressure. After the decimalization, many retail investors grasped large savings from the cost of the execution.

The Big Bang also profited from the decimalization. This lead in many large firms such as the Wall Street cut down their expenses such as the banking coverage for the public securities issuers. This also led to the firms focusing on new investments such as the OCT assets. The decimalization also led to the losses of many securities firms. The firms created new strategies such as employing leverage and to also focus on the over-the-counter assets. The security firms therefore played the largest role in creating the subprime crisis.

This is because they were forcing their clients to reduce their assets that they need to finance. Fair value accounting is the third reason that caused the subprime crisis. Fair value accounting was implemented in 2007 by the Financial Accounting Standards Board which is an arm of the SEC after being developed for the past two decades. Many large accounting segments and economic professions promoted this idea of fair value accounting. The other people who supported this idea were the financial services community leaders. This fair value accounting has caused many problems to the economy.

This idea was established after the need of making the securitized assets transparent as this will lead in making the assets more efficient than the bank assets. There was also the need of making the securitization markets liquid and transparent since it was anticipated that it will expand from the agency paper. The reason for the fair value accounting was to make the commercial banking industry role to decline. This was to make the banks to act as agents and sponsors of these assets. This idea was established to assume that all the assets in the markets were stable and liquid.

The financial technology had rapidly accelerated leading to many assets classes which are highly liquid. Wall Street firms encouraged the use of the fair value accounting so that they could support the over the counter markets. It was necessary that the security firms to combine the fair value accounting and the third party guarantees as well as the external rating so that they may satisfy the investors. This was because the defects inherited from the CDOs and other structured assets that are complex such as the liquidity risk were going to be overlooked.

The fair value accounting was supported by the Federal Reserve economists since they proposed the risk-based capital requirements of the Basel II capital framework. The other global regulatory agencies also supported this risk-based capital requirement. Many banks in the U. S. use the fair value of assets in the capital adequacy analysis. This may lead to higher capital charges of the Basel II. Many other people have also support the use of the Basel II. The banks have been able to use the SIVs in the moving of the assets off the balance sheet.

Banks have been forced to take the total losses on the assets due to factors such as the structured assets’ near-zero liquidity and the Sarbanes-Oxley’s legal structure. Due to the use of the fair value accounting, many banks have also been forced to write down CDOs and other derivative assets. Initially, companies had been using the book accounting due to the fact that the investments cost are accurately reported in the book accounting. Banks have now been forced to take the losses due to the rules of the fair value accounting since the CDOs and the other structured assets have no market.

The fair value accounting has caused the subprime crisis and has therefore threatened the largest U. S. commercial banks’ safety. The use of fair value on the review of the illiquid assets has forced many investors to spend more of their resources. There are other factors that led to the subprime crisis. The Inter-bank was being seized up since many banks did not want to lose their money to institutions that were not credit-worthy and therefore it made the ECB and the Fed to flood the money with liquidity. This led to the shooting up of the money interests’ rates above the central banks’ target.

The banks feared that they would be needed to bail out the commercial paper markets by contributing many billion dollars. This was caused by the fact the commercial paper investors had gone on strike. The commercial paper investors went on strike since they felt that the commercial paper were not safe anymore. This is because they had invested on financial asset-backed securities such as the subprime mortgages in the U. S. Banks used the subprime mortgages to help the people with no income to be able to lend money for building house.

This was also due to the reason that the prices of building the house were on the rise. The banks did not want to suspend the loans so they gave the loans to anyone who wanted it. There was a crisis since the subprime loaners were not able to pay back the money. The other reason why there is a crisis is that there has been no clear way of handling the commercial paper. The other reason which led to the emergence of the subprime crisis was due to the fact that the interest rates of the mortgages financing had increased with time and also the housing prices had increase in the U.

S. This problem made the investors such as the financial institutions to seek solutions for the problem. The investors wanted the securitization of the subprime mortgages which is the process of turning low investment grade assets into AAA and other investment grade liabilities. This process exposed the investors to great risks. The number of the subprime mortgage loaners increased during the year with a percentage of 10% of the outstanding mortgages loans in 2005 and a 13% in 2006. The other reason why there was a greater risk was because the financial markets were liquid.

The other major cause of the subprime crisis was the subprime mortgages of the CDOs and the CRT instruments. This is because they were from AAA to non-investment grade. In 2001, there was a 4% delinquency rate of the prime adjustable rate mortgages and by the end of 2006 the delinquency rate was less that 4%. The delinquency rate of the subprime adjustable rate mortgages was about 15% by 2002 and by the end of 2006 it was 14%. In 2006, 2. 45 million U. S. home owners are borrowers of the subprime adjustable rate mortgages. This statistics is about 4. 9% of the current home owners.

10. 13% of these home owners were delinquent meaning that they have many payments overdue. The four reasons that made the rate of the delinquencies to increase were because the subprime borrowers were not creditworthy and their mortgages had a large loan-to-value ratio. The subprime borrowers were also allowed to borrow two home mortgages and their homes were financed 100%. The other reason that caused an increase in the delinquencies was the fact that the subprime loans were short-reset meaning that they were 2/28 or 3/27 hybrid subprime adjustable rate mortgages.

These types of loans have a low fixed teaser rate during the first two years. After the two to three year, the rates rest from semi-annual rate to a higher rate. This therefore led to a distress to the subprime borrowers. The third reason is that the subprime borrowers are not able to repay the loans back since they were not able to sale their homes due to the decrease in the appreciation of the U. S. house prices from April 2005. Lastly, the mortgages originators made a decline in the credit standards. The banks were pressurized in increasing the subprime mortgages supply.

This is because there was increase in the higher yielding assets demand by the investors. The home equity loans grew since the CDOs’ high demand for BBB mortgages-backed bonds which was because the bonds had high yields. The purchases of the CDO trust were then financed by issuing of the CDOs that are rated AAA. This was to make lower yield payments. The frauds increased since many borrowers of the loans and the brokers had taken the advantage of the mortgages loaning process due to the fact that the subprime mortgages were credited to unworthy borrowers.

There were many key players that enhanced the subprime crisis. Some of the key players that caused the subprime crisis include the rating agencies, the mortgages brokers and lender, monolines insurers and the ABS trust, the CDO and the CDO squared equity holders. The other key players include the financial institutes, the economy and the central banks. The Rating agencies were responsible for warning the investors in the subprime markets deterioration.

Many investors relied on the rating agencies’ rates of the mortgages bonds and the asset back commercial paper - ABCP. These products are issued by the structured investment vehicles and the derivative product companies. Many investors also relied on the rating agencies for the risk assessment process. The other people who were involved in the subprime crisis were the mortgages brokers and lenders. The subprime mortgages loans were mostly issued by the brokers. The interest rate was then increased by the Fed thereby enhancing the problem of the subprime.

The ABS trust, the CDO and the CDO squared equity holders enhanced the defaults in the subprime markets. The monolines were brought into a halt and therefore caused the rating to change from the AAA rating. The financial institutions had causes the subprime crisis since there were changes in the regulatory framework of the banks to the Basel II. The issues that increase the subprime crisis were the difficulty in valuing the structured credit products and the lack of transparency in the loan application process in the credit markets.