Global Financial Crisis
The 2008 Financial Crisis caused a drought like condition for people all over the world and specially United States. The rates of unemployment rose high and all types of investments proved to be wrong. Trillions of dollars were lost. It all started with United States and percolated down to so many countries that it became the Global Financial Crisis. As we all know, it is the basic human behavior to blame something else for their troubles, several people have pointed their fingers at greed or credit.
However, it is the belief of many bankers and economists that it was caused by unethical use of fair-value accounting, which is basically a rule for measuring companies’ liabilities and assets. Fair-value accounting has had a major effect on most of the financial troubles of almost all the nations. However, investigative evidences till date point mostly towards the overvaluation of banks’ assets. Could accounting rules have caused a world-wide financial crisis? That is what we will be discussing here.
We will also discuss what happened in US as it is the epicenter of this GFC, the measures taken by Financial Accounting Standards Board (FASB) of US, the responses and actions taken by International Accounting Standards Board
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Because of the financial crisis, the market for several products collapsed. Assets that, either don’t have a regular market that provides accurate pricing or valuations or rely on a complex set of reference variables and time frames, must be ‘marked-to-model’. In such a situation, assumptions and guesswork must be taken into account to assign value to an asset. Fair-value accounting gives a much more volatile view of a financial statement.
Based on this reason, Swagerman insisted that fair-value accounting strengthened the GFC. And, it was the same reason that the real estate billionaire Sam Zell also said that this was all due to the mark-to-market valuation methods. As it all started with the US, let us start with what happened there. Highly complex financial instruments called derivatives, which are also called by some economists as the “weapons of mass destruction”, were introduced in 1990s.
Because of the deregulation of derivatives in the US, the big investment banks and financial conglomerates, like JP Morgan, Citibank, Lehmann Brothers, Morgan Stanley, etc. introduced “Collateralized Debt Offerings” or CDOs, a type of Asset Based Securities and collateralized by debt obligations including bonds and loans. Then, there were also those Rating Agencies like Standard & Poor’s; Moody’s which falsely rated the derivatives as totally safe instruments (AAA rating).
These securities became so popular in US that the investment banks started selling more and more of them, ultimately urging the ordinary people to take more and more loans from the market, thus affecting the Securitization Chain (which is the chain consisting of Home Buyers at the first stage, Lenders at the second, Investment Banks at the third and Investors at the last stage). Prices of homes skyrocketed and ultimately led to the sub-prime mortgage crisis of 2008. Thus, we can say that the prices of homes were not fairly valued in US.
Take the case of Ramalinga Raju, chairman of Satyam Computer Services, who made an accounting fraud of around INR 8000 crores, which left India paralyzed and the investors questioning the nation’s moral and financial stability. It was all because of that fraud he did that the stock price of Satyam initially touched highs; otherwise you can see its price now. The company was running into losses, but still Raju made the deliberate accounting error just to keep investors happy about the company’s performance. Now, let us talk about how IASB responded to GFC and let us see the actions it took.
In September 2005, the IASB took the initiative to prepare an exposure draft regarding international fair-value accounting standards. The main reason behind it was to reduce the complexity of the guidance on measuring fair value. This draft became the single source of guidelines for all fair-value measurements and increased convergence in all International Financial Reporting Standards. IASB then decided to publish a paper to summarize its preliminary views about fair-value measurement, which would be drafted at a later stage after discussions.
The FASB had already developed its own fair-value measurement standard, SFAS 157, which provided the detailed and consistent guidance on that topic. This draft stated about fair-value measurement in inactive markets and also the incorporate guidance published by the FASB on measuring this fair-value in such markets. It got published in May 2009. It contained all the measures to avoid the consequences of the global financial crisis of 2008. The IASB and FASB, in June 2010, together published an exposure draft of amendments that contained methods to capture uncertainty analysis for fair-value measurement.