Subprime Crisis and Fair Value Accounting

SUBPRIME CRISIS AND FAIR VALUE ACCOUNTING

1. Fair-value accounting is defined by FAS 157 as "a price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date". It is also called mark-to-market accounting when market prices are used to determine fair value.

Critics have blamed this method of accounting to be 70% responsible for the subprime crisis and have pointed out that fair value accounting created problems in the measurement of subprime positions. Critics have claimed that this method of accounting led the banks to value assets at fire-sale prices. As more and more liquidation sales took place, the asset prices declined further, and these declines resulted in an increased demand, from lenders, for additional collateral that again led to more distress and liquidation sales and reduction in asset values. This led to a downward spiral during the bust period.

However, it is still difficult to argue that fair–value accounting was the reason that contributed to the crisis. The downward spirals and asset-fire sales did not necessarily occur as a direct result of fair value accounting. Banks were heavily relied on collateralized borrowings during the boom period and their leverage was also high, however, the amount of debt that was obtained by such collateralized borrowings depended on the market value of the assets used as the collateral and not the book value that is used in fair-value accounting. Therefore, it can be inferred that the investment banks which had short-term borrowings and were substantially exposed to subprime mortgages would have suffered, regardless.

Moreover, fair value accounting promoted transparency and provided a clear measurement of the underlying value of assets unlike historical cost accounting. Possibly, the role of fair value accounting was limited because its role in the balance sheets and capital requirements of the banks were...