Essay on Fair Value Issues and Sub Prime Crisis

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Fair Value Issues and the Sub Prime Crisis

Fair Value Issues and the Sub Prime Crisis
By
David Robinson
Executive Director
Ernst & Young1

Abstract
A debate has developed about an old chestnut of accounting – fair value determination. The purpose of this paper is to detail recent observations from the sub prime and subsequent liquidity crisis and discuss the application of both Australian and US accountings standards to the issue of fair value. In recent times, there has been considerable commentary regarding the use of fair value accounting and its impacts during the crisis. In particular questions have arisen about whether current market prices are consistent with the definition of fair value in
AASB 139 and FAS 157, or whether current market prices are more indicative of distressed sales. Prepared for the 13th Melbourne Money and Finance Conference
Melbourne June 2008

1

The views expressed in this paper are those of the author and do not necessarily represent those of Ernst & Young.

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Fair Value Issues and the Sub Prime Crisis

Introduction
The unfolding financial turmoil in world economies bought about by the sub prime crisis has prompted the government and private sectors to reconsider policies, business models and risk management practices. It has also caused some commentators to raise questions about the accounting, disclosure and risk management practices of banking and industrial corporates. In recent times, there has been considerable commentary regarding the use of fair value accounting and its impacts during the crisis.
A short synopsis of the sub prime crisis
Since 2001, against the backdrop of low interest rates and booming asset prices, credit aggregates, alongside monetary aggregates, had been expanding rapidly in most economies.
Simultaneously, expansion in the global real economy in particular in China and India further fuelled the growth in business activity and expansion of credit. Despite the rapid increase in credit, however, the balance sheets and repayment capacity of corporations and households did not appear to be under any strain. The high level of asset prices kept leverage ratios in check while the combination of strong income flows and low interest rates did the same with debt service ratios. Across a wide spectrum of asset classes, volatilities and risk premia looked exceptionally low, including to varying degrees in fixed income, credit, equity and foreign exchange markets. This was also a period where excess liquidity in the world caused investors to chase higher yields and saw a loosening of credit standards.
The main manifestation had been the extraordinary expansion of credit risk transfer instruments, which permitted the transfer, hedging and active trading of credit risk as a separate asset class. Examples included credit default swaps (CDSs) and, in particular, structured credit products, through which portfolios of credit exposures could be sliced and diced and repackaged to better suit the needs of individual investors. This category included, in particular, collateralised debt obligations (CDOs), backed both by cash instruments, such as primitive securities, loans or asset-backed securities, and by derivative claims, such as CDSs and CDOs themselves.
The nature of many of the credit linked instruments is such that the securitiser — who could be either the mortgage originator or another firm that purchased the mortgages from the

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Fair Value Issues and the Sub Prime Crisis

originator—places mortgages in a bankruptcy-remote entity that issues various tranches of mortgage backed securities. These tranches are sequenced from most senior to most junior.
The most senior tranche is sized as large as possible while still obtaining a AAA rating for that tranche from credit rating agencies. The most junior (“equity”) tranche is unrated and sized as small as possible while still obtaining the lowest investment grade rating for the second most junior tranche. Typically the securitiser
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