Once Upon a Time, in the Land of Subprime

APRIL 2008 - A cartoon that has received wide circulation via the Internet did a remarkably good job of explaining the current subprime mortgage crisis while poking fun at the major players. The cartoon manages to include all of the following elements:

• A potential homeowner with less-than-stellar credit applies for a mortgage with little or no money down and no income verification.
• The mortgage broker qualifies the borrower based on a low “teaser” interest rate in order to receive a commission on the loan.
• The loan is sold to an investment bank that packages such loans into collateralized debt obligations (CDO) and sells them to unsuspecting investors, so the broker has no disincentive to qualify high-risk borrowers for loans they can’t afford to repay. [As long as housing prices increased, the risk associated with this practice was somewhat mitigated, and, after all, not all borrowers would default.]
• The CDOs would be separated into three categories (tranches): the “good,” the “not-so-good,” and the “ugly,” with the interest rate proportional to the level of risk involved.
• Bond insurance would be purchased for the “good” tranche so credit-rating agencies would give it an AAA to A rating (and these investors would be paid first). The “not-so-good” tranche would get a BBB to B rating, and the banks wouldn’t ask for the “ugly” tranche to be rated at all.
• Wall Street banks would simply hold onto the “ugly” tranche themselves and charge a very high interest rate.
• In accordance with current accounting standards, the CDOs were placed into holding companies called special purpose vehicles (SPV), and, consequently, did not appear on the banks’ balance sheets, even though the mortgages were used as collateral for the new securities.
• Everyone was caught off-guard when the housing market turned downward and foreclosures spread through the underlying mortgages; the bond insurance turned out to be worthless because the insurance companies failed to set aside adequate funds to cover the losses.

Unfortunately, this story does not end “happily ever after.” The subprime mortgage mess has stoked the fires of an already simmering recession, and despite the Federal Reserve’s efforts to mitigate the intensity of the economic fallout by reducing the Federal Funds rate, the problems in the U.S. housing market have persisted and spread to the global credit markets. Consumer confidence is down, and that is reflected in home sales and prices.

Lessons Learned

A loss of confidence in our financial market system has been at the root of every significant economic meltdown. A lack of trust in the financial statements and the audit process triggered a precipitous fall of the stock market after the Enron and WorldCom scandals. Those events prompted Congress to pass the Sarbanes-Oxley Act to restore investor confidence. This time, fingers are pointing at the credit-rating agencies for a breakdown in the process. But as you can see above, there are plenty of market participants to blame.

One obvious element that the subprime debacle and the Enron scandal have in common is the use of SPVs or special purpose entities (SPE) to avoid transparency in questionable transactions. When will accounting regulators learn? Investors are willing to accept some risk in the investment process, but what’s unacceptable is not being told the truth about the level of risk they’re taking with their money. Because of the uncertainty and volatility in the financial markets, investors need better information about the relationship between an organization and the SPVs or SPEs it creates to house liabilities, and which entity is responsible for potential losses.

But even as accounting regulators have dropped the ball, legislators are again stepping in. For example, Senator Jack Reed (D-R.I.), chairman of the Banking Subcommittee on Securities, Insurance, and Investments, wrote a letter to FASB Chairman Robert Herz and International Accounting Standards Board (IASB) Chairman Sir David Tweedie asking them to explain the main differences between FASB and IASB accounting and disclosure standards for off–balance sheet transactions. Congress, along with the American public, is wondering what our financial accounting regulators have been doing to prevent a regular recurrence of these crises. Were they asleep at the switch? And when the alarm went off, did they simply press the snooze button?

As always, I welcome your comments.

Mary-Jo Kranacher, MBA, CPA, CFE
Editor-in-Chief
mkranacher@nysscpa.org

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