Subprime Enron

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Fair value accounting

Fair value accounting is a financial reporting approach in which companies are required or permitted to measure and report on an ongoing basis certain assets and liabilities (generally financial instruments) at estimates of the prices they would receive if they were to sell the assets or would pay if they were to be relieved of the liabilities. Under fair value accounting, companies report losses when the fair values of their assets decrease or liabilities increase. Those losses reduce companies’ reported equity and may also reduce companies’ reported net income.

The goal of fair value measurement is for firms to estimate as best as possible the prices at which the positions they currently hold would change hands in orderly transactions based on current information and conditions. To meet this goal, firms must fully incorporate current information about future cash flows and current risk-adjusted discount rates into their fair value measurements.

Reasons for the Subprime Crisis:

1. Low interest rates:

Many economists believe that historically low interest rates caused in part the U.S. housing bubble. The Federal Reserve Board cut short-term interest rates from about 6.5 percent to 1 percent, in response to the crash of the dot-com bubble in 2000 and the subsequent recession that began in 2001. Mortgage rates are generally set in relation to 10-year Treasury bond yields, which, are affected by federal funds rates. The Fed has recognized the connection between lower interest rates, higher home values and the increased liquidity that the higher home values bring to the overall economy. In a 2005 report by the Fed, “International Finance Discussion Papers, Number 841, House Prices and Monetary Policy: A Cross-Country Study,” the agency said that house prices, like other asset prices, are influenced by interest rates, and in some countries the housing market is a key channel of monetary policy...