Accounting’s Role in the Financial Crisis

Accounting’s Role in the Financial Crisis

Subprime mortgages are a financial innovation designed to provide home ownership opportunities to riskier borrowers in the U.S. The banks lend this group involved a particular mortgage design feature that resulted in linking the outcome to house price appreciation. This financial crisis happened in 2007-2008 was a system-wide bank run. It didn’t happened in traditional banking system, but occurred in the securitized banking system which used repurchase “repo” agreement.

An important part of the subprime mortgage innovation was how the mortgages were financed. In 2005 and 2006, about 80 percent of the subprime mortgages were financed via securitization. The mortgages were sold in residential mortgage-backed securities (RMBS). RMBS involves thousands of mortgages and sell the pool to a special purpose vehicle (SPV) which finances their purchase by issuing investment-grade securities with different seniority in the capital markets. Securitization spawned many new financial instruments and usages for old instruments. The pieces of the securitization process fit together.

After the subprime financial crisis erupts, many people re-think the causes of this financial crisis. Some scholars points that the accounting rules had played a role in this financial crisis, especially the “Off-Balance Sheet”, which reporting of securitized assets, is one of the causes of the collapse. From the financial accounting perspective, I will try to explain the cause and the solution of the subprime financial crisis through in-depth analysis.

1. Introduction of the Off-Balance Sheet, and Leverage Ratio

2.1 The Off-Balance Sheet

There are three important components in the securitized banking cycle, money-market mutual funds (MMMF), securitization and repurchase transactions (Repo). They are the key elements of “off-balance sheet” financing. Repo is a contract in which the seller of securities, such as Treasury Bills, agrees to buy...