Subprime Crisis: Problems Caused by Accounting

The subprime mortgage crisis was caused by a myriad of factors coming together. There was faulty lending, speculative borrowing, there was an ill conceived secondary mortgage market and then there was also the wrong accounting techniques being used. In this article we will focus on the problems with the accounting used by the firms in the subprime mortgage crisis. It is important to note that the crisis was not an accounting fraud. This means that the books were not cooked and the numbers were not made up. All the accounting techniques used were perfectly legal. They were legal yet flawed.

However, the accounting techniques did magnify the crisis once it happened. The accounting technique which was brought into question by the critics is called mark to market accounting. We will discuss the pitfalls of the same and how it related to the subprime mortgage crisis in this video.

Mark to Market Accounting

It is important to note that this is not the first time that mark to market accounting is being criticized. It has always been considered to be a very aggressive accounting method. Nobel Prize winning economist Milton Friedman has criticized it severely on many occasions. Also, this method was blamed in the biggest accounting fraud in Corporate America i.e. Enron Inc.

Let’s briefly understand how mark to market accounting works. Usually when an investment is purchased it is recorded in the balance sheet at cost price. This cost price remains the same on the balance sheet regardless of what the market value of these assets is. The market value is recorded as a gain or loss only when the asset is sold. For instance, if I buy a security for $100, it reflects on my balance sheet as $100 even if its market value is $130. Only when I sell the security for $130 does the $30 gain get recorded. As long as it is on the balance sheet no gain or loss is recorded.

In the case of mark to market accounting, this is not the case. Gains and losses are immediately recognized and booked to the profit and loss account. Hence in our example, if we purchase the security for $100 and its value changes to $130, we mark these securities to market. This means that we recognize $30 of additional gain. Remember that no transaction has taken place and this gain is purely fictional. The firm does not have this additional $30 to justify the entry. However, this is how mark to market works and this is what perpetuated the subprime mortgage crisis cycle.

The Upward Spiral

Now, the subprime mortgage saw both the upside and the downside of the mark to market accounting. Let’s see the upside first. During the borrowing boom, home prices were rising, interest rates were falling and there were almost no defaults. Hence, the securities purchased by investors or held by investment banks for trading were rising in value. In many cases, they were rising at double the rate of the other securities because of the perceived financial innovation. In these heydays, the companies holding these securities were constantly recognizing the gain in the profit and loss accounts. This gave unwary investors the picture that the company is earning record profits. This made their stocks trade at higher multiples and made the company appear more valuable than it really was!

Hence, the mark to market accounting did not create the subprime boom in the first place but rather perpetuated it. It allowed companies to recognize fictional gains and created a stock market boom which was completely based on the boom of the mortgage securities market!

The Downward Spiral

The downward spiral was much more painful for the companies involved. This is because just like the gains, the losses also have to be marked to market on an immediate basis. Hence if the value of $100 security falls to $80, the company is required by accounting standards to immediately recognize the $20 loss. This proved very costly on the fateful day that Lehman brothers fell.

On the day that Lehman Brothers collapsed, the mortgage securities market took a nosedive in valuation. Many of the securities which were highly valued were now being valued at close to zero. As a result of this all the investment banks and investors that were heavily invested in these securities had to take an immediate write down in the valuations. Now, it needs to be understood that these securities were not sold yet and the value of these balance sheets remained uncertain. However, there was an immediate write down. As a result, the balance sheets of many of these companies started appearing to be unhealthy. Therefore there was a massive panic and sell off in the stock markets. What started as a bust in the mortgage market quickly threatened the existence of the global financial system.

Once again, mark to market accounting did not cause the catastrophe. However, it aggravated the downside by magnifying it.

Conclusion

Mark to market accounting is a dangerous accounting policy. It must be used very carefully and with caution. Even more so when it is being used to account for speculative securities like the ones that were being used in the mortgage markets. The subprime mortgage mess ended with severe discussions on mark to market accounting as well as curtailing its widespread usage.

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