The financial crisis that started in the middle of 2007 until the end of 2008 resulted in the collapse of many financial institutions such as Lehman Brothers and Wachovia (Laux & Leuz, 2010). The financial crisis started with the collapse of housing market in US that leads to the collapse in price of financial instruments whose values are inseparable with housing prices. When there is a decrease in the value of bank assets, recognition of impairment expense in Financial Statement is necessary if Fair Value Accounting (FVA) is used. However, the FVA are being said to cause an over write-down of the value of assets during recessions while over leverage during boom periods, although the amount recognized may not actually be the recoverable amount if the holder were to hold the asset to the future (Scot, 2010). This shows the procyclical effects of FVA.
As capital values decline due to recognition of impairment, firms must scramble to maintain the specified capital ratios required ...view middle of the document...
In doing so, management prevents having to record the asset to an even lower market price but creates contagion effects for other banks.
Moreover, as the supply of assets increase while demand decrease, price will reduce even further. In consequences, bank may unable to originate new loans such as extending credit to commercial businesses which create the credit crisis and contraction of the economy. In addition, when the credit agencies see declining capital margins, they may downgrade the company’s credit ratings. This will cause borrowing to meet capital requirements more difficult (Gingrich, 2008). Declining capital and credit ratings cause the company’s stock prices to decline and some suffer from bankruptcy or takeover by government which then leads to the huge 2008 Financial Crisis (Barth & Landsman, 2010).
Subprime crisis is one of the financial crisis which centers on trillions of dollars’ worth of mortgage loans that were packaged together into financial instruments known as Mortgage-Backed Securities (MBS). Subprime mortgage were bought by banks and Wall Street firms. However, as home prices started to fall and foreclosures rose as the subprime borrowers started to default on their loans, the value of these securities plunged which eventually making almost no market for the securities (Isidore, 2008). Some experts commented that it was not real financial losses from these securities but it is due to the use of FVA in evaluating the MBS (Stammer, 2008). Many skeptics believe that while FVA sounds good theoretically but in reality the free play of market forces may not always reflect the real value of a financial asset ( Tata Mutual Fund, 2011). The FVA may become a messenger of death during financial crisis where the market price for some securities will plunged even when the securities are generating high return due to a few transactions in an illiquid market (Stammer, 2008). FVA method can have serious repercussions in a bear market, leading to much huge losses than traditional accounting. On the other hand, it had even more serious repercussions when applied to new, thinly trade mortgage securities, an effect that lead to the credit crisis of 2008 and bank failures (Elmerraji, 2009).