Financial crisis in 2008

Posted by Melda Research on March 6th, 2019

Introduction
The financial crisis in 2008 caused a lot of finger-pointing at the fair value accounting for the financial instrument. Fair value accounting involves reporting the liabilities and assets on the balance sheet at the fair value and recognizing the changes in the fair value as losses and gains on the income statement (Veron, 2008). In this report, we discuss whether fair valued caused the financial crisis in 2008 while focusing on liquidity.

Financial crisis
The critics of fair value accounting causing financial crisis argue that fair value caused the financial institutions to take unnecessary losses which resulted in the elimination of the investment banking industry and also bankruptcy of banks. Managers tend to evaluate liquidity risk through gauging the trend and also the stability of the funding sources (Wallison, 2009). When considering the fair value of liquidity, it tends to increase the marketability of certain illiquid assets. In the case of the financial crisis in 2008, we understand that fair value can enhance pro-cyclical selling behavior in a crisis. It may shorten the time for reacting to the liquidity shortage and exacerbate the problems as all banks take the same actions.
FAS 157 tend to favor using observable market price to value available-for-sale securities. Therefore, during the crisis, auditors marked assets at distressed market prices that were below their value if measured based on the cash flows that the investment would make. The excessive FVA losses in the subprime mortgage portfolios in 2007 did cause lenders to demand more collateral (Veron, 2008). Thus, companies sold their assets at distressed values so as to meet capitalization requirements that depressed market prices and caused investor uncertainty and market illiquidity. During the time, banks sold assets at liquidation prices where they recognized further losses.
While considering the fair value in terms of liquidity, it is clear that it contributed to the financial crisis. The objective of fair value accounting of providing a transparent representation of the financial position tends to assume a high degree of stability and liquidity in the market. With the invention of a complex financial instrument, wall street did create a market with high liquidity risk (Wallison, 2009). During the crisis, the investors did overlook the liquidity risk and the securities because of overreliance on the third party rating agencies and also guarantees.
When the market changed for the worst, and the prices of assets fell, the nature of the financial instruments caused uncertainty and also market illiquidity. The liquidity risk and frozen markets instead of credit risk or change in the expected cash flow did cause the asset prices to fall and resulted in financial institutions recognizing huge losses on their income statement. Therefore, it is clear that the fair value accounting did cause the banks to take excessive write-downs on assets because the economic value did not change enough to justify the cut (Veron, 2008). If the fair value accounting was not present, the billions of dollars in the trading book losses by Citigroup, and Merrill Lynch would not be that large or even avoided entirely.
In 2008, the securitized asset markets were not perfectly liquid. The losses in the MBS portfolios and other ABX elicited price decline (Wallison, 2009). The banks marked their assets down to the market value and also their equity absorbed the trading losses; thus, decreasing the balance sheet size. As a result, the banks considered selling off assets and also paying down the liabilities so as to decrease their leverage ratios. The greater sale of the assets also depressed the asset prices that led to weaker balance sheets and interaction between the price fall and leverage adjustment intensified the process.
The fair value did play a part in the crisis. The excessive asset sales by banks that resulted in a procyclical decrease in leverage amplified the asset price decline and the subsequent contagion (Wallison, 2009). The fair value normally requires the asset write-downs based on the exit prices that were artificially low because of the illiquidity; hence, poor indicators of the financial asset fundamental values. Therefore, the fair value based write-downs caused excessive asset sales by the banks that were the sources of the amplified asset price declines.
Conclusion
The fair value accounting and the role in the 2008 financial crisis tend to spark controversial debate among business leaders, bankers, and academics. Based on the discussion presented above, the fair value accounting did play a little role in the crisis. In regards to the investment banks, they normally use the accounting method in valuing most of their assets and hold a significant portion of overall financial assets in the economy. Therefore, when using fair value accounting in measuring the majority of the assets in the balance sheet, it causes pro-cyclical balance sheet size and leverage. Investment banks tend to apply the accounting method in most of their assets, and the banks have a large influence to financial markets. Thus, I believe that the fair value accounting played a role in the financial crisis.
 
Reference
Veron, N (2008). Fair Value Accounting is Wrong Scapegoat for this Crisis. Accounting in Europe, 5(2)
Wallison, P (2009). Fair Value Accounting: A Critique. EconoMonitor.

Sherry Roberts is the author of this paper. A senior editor at MeldaResearch.Com in pay someone to write my research paper services. If you need a similar paper you can place your order from write my research paper online services.