The purpose of this essay is to describe implications of the subprime crisis and the credit crunch it has engendered (collectively the “subprime crisis,” except when necessary for clarity) for accounting, meaning recognized accounting numbers and disclosures that elucidate those numbers. These implications depend on the interplay among attributes of subprime mortgages and other positions, the evolution of market prices and illiquidity during the crisis, and the requirements of the applicable accounting standards.
While credit losses on subprime positions are recorded under various standards, I focus on losses recorded based on the fair value measurement guidance provided in FAS 157, Fair Value Measurements. I also discuss issues that have arisen in accounting for securitizations of subprime assets under FAS 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, and for the entities used in these transactions under FIN 46(R), Consolidation of Variable Interest Entities.
My intended audiences are preparers, auditors, and users of financial reports who must deal with the crisis as it unfolds and accounting standard setters, researchers, and teachers who want to use the crisis as learning experience for themselves and their students. While sadly costly and disruptive to families, firms, and the overall economy, I deem the subprime crisis to be the signal researchable-teachable moment of my two-decade-plus career as an accounting academic focused on financial reporting by financial institutions for financial instruments and transactions. I believe that accounting and other academics have the responsibility to understand and employ the crisis to the benefit of our disciplines, students, and society.
The subprime crisis began in earnest in February 2007 and has entered its second year with a vengeance. In July 2007, the subprime crisis ended a three-year period of unprecedented global liquidity and spawned the credit crunch. Since then, market illiquidity has become increasingly broad and severe in several distinct waves over time, and now extends well beyond the markets for subprime positions. For example, it is now difficult for lenders to raise or maintain financing of many types of consumer loans, including credit card, automobile, and student loans, and so borrowers increasingly cannot obtain such loans.
Bond financing has dried up for all but the best corporate and municipal credits, in part due to concerns about the capitalization and exposures of the major bond insurers. The potential for further contagion appears high, with even prime mortgages looking shaky. Many parties now view the subprime crisis as the worst real estate, credit, and very possibly overall economic crisis in the United States since the Great Depression.
Notably, there have been observable feedback effects between the subprime crisis and the credit crunch. As firms have announced losses on subprime positions, debt markets have become more averse to holding those positions and increasingly illiquid, causing the fair values of the positions to decline further and become more difficult to measure. A likely reason for these feedback effects is the opacity of many subprime positions.
This opacity is attributable in part to the complex partitioning of the risks of these positions through (re)securitizations, credit derivatives, and other financial transactions. It is also attributable in part to the fact that many subprime positions are off-balance sheet in the so-called “shadow banking system.” As a result of this opacity, market participants now either aggressively price protect themselves when bidding for those positions or avoid them altogether. Many holders of the positions have now “capitulated” and are selling subprime positions at virtually any price to remove the perceived taint from their balance sheets. Various other types of adverse feedback effects are evident in the economy and of deep concern to economic policymakers.
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