Financial Crisis of 2007-2009 - Can this be attributed to Financial reporting:-

The financial crisis of 2007-2009 was one of the worst financial crisis since the Great Depression of the 1930s. It contributed to the failure of key businesses, declines in consumer wealth, substantial financial commitments incurred by governments, and a significant decline in economic activity. Both market-based and regulatory solutions have been implemented or are under consideration, while significant risks remain for the world economy.

The collapse of a global housing bubble, in the U.S. in 2006, caused the values of securities tied to housing prices to decline thereafter, damaging financial institutions globally. Critics argued that credit rating agencies and investors failed to accurately price the risk involved with mortgage-related financial products, and that no measures were taken by the governments to adjust their regulatory practices to address 21st century financial markets. Governments and central banks responded with unprecedented fiscal stimulus, monetary policy expansion, and institutional bailouts.

Many factors directly and indirectly caused the ongoing financial crisis of 2007-2009 and were related to particular causes. One category of causes created a vulnerable or fragile financial system, including complex financial securities, a dependence on short-term funding markets, and international trade imbalances. Other causes that include are high corporate and consumer debt levels. The ongoing foreclosure crisis and the failures of key financial institutions were also the major cascading effects. Regulatory and market-based controls did not effectively measure the buildup of risk. Some causes relate to particular markets, such as the stock market or housing market, while others relate to the global economy.


Financial Models:-

The limitations of a widely-used financial model also were not properly understood. The formula to valuate the price of CDS according to various financial models which stated that the price of CDS (Credit Default Swaps) was correlated with and could predict the correct price of mortgage backed securities. Because it was highly tractable, it rapidly came to be used by a huge percentage of CDO (Collateralized Debt Obligation) and CDS investors, issuers, and rating agencies. As financial assets became more and more complex, and harder and harder to value, investors were reassured by the fact that both the international bond rating agencies and bank regulators, who came to rely on them, accepted as valid some complex mathematical models which theoretically showed the risks were much smaller than they actually proved to be in practice.


Off-balance sheet financing:-

Complex financing structures called structured investment vehicles (SIV) or instruments enabled banks to move significant amounts of assets and liabilities, including unsold CDO's, off their books. This had the effect of helping the banks maintain regulatory minimum capital ratios.


Capital Market: - Private capital and the search for yield

The worldwide fixed income investments sought higher yields than those offered by U.S. Treasury bonds early in the decade, which were low due to low interest rates and trade deficits. Further, this pool of money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe, income generating investments had not grown as fast. Investment banks on Wall Street answered this demand with the mortgage-backed security (MBS) and CDO, which were assigned safe ratings by the credit rating agencies. In effect, Wall Street connected this pool of money to the mortgage market in the U.S., with enormous fees accruing to those throughout the mortgage supply chain, from the mortgage broker selling the loans, to small banks that funded the brokers, to the giant investment banks behind them. By approximately 2003, the supply of mortgages originated at traditional lending standards had been exhausted. However, continued strong demand for MBS and CDO began to drive down lending standards, as long as mortgages could still be sold along the supply chain. However, this speculative bubble proved unsustainable.


Financial product innovation:-

The ongoing development of financial products designed to achieve particular client objectives, such as offsetting a particular risk exposure (such as the default of a borrower) or to assist with obtaining financing was also one of the key factors that led to the crisis. Examples pertinent to this crisis included: the adjustable-rate mortgage; the bundling of subprime mortgages into mortgage-backed securities (MBS) or collateralized debt obligations (CDO) for sale to investors, a type of securitization; and a form of credit insurance called credit default swaps(CDS). The usage of these products expanded dramatically in the years leading up to the crisis. These products varied in complexity and the ease with which they can be valued on the books of financial institutions.


Mark-to-Market Accounting:-

The other main cause was the way in which valuation of complex and illiquid securities such as MBS and CDO held as assets on the books of financial institutions. The debate arises because accounting rules require companies to adjust the value of such securities to market value, as opposed to the original price paid. Many large financial institutions recognized significant losses during 2007 and 2008, as a result of marking-down MBS asset prices to market value. The combination of losses and margin calls resulted in further forced sales of MBS and emergency efforts to obtain cash. Markdowns may also reduce the value of bank regulatory capital, requiring additional capital raising and creating uncertainty regarding the health of the bank.


Conclusion:

From the views expressed by the author the following conclusions can be drawn:-

  1. Improving transparency and accuracy of financial information could help rebuild shattered investor confidence

  2. The structure of securitized assets could be made more transparent by creating a data bank that combined information from all the asset pools.

  3. The purpose of a systemic risk regulator would be to address the failure of any entity of sufficient scale that a disorderly failure would threaten the financial system.

  4. Enforcing stricter capital requirements for companies and insisting that assets be more liquid so as to booster investor confidence.

  5. Credit agencies to provide investors with reports for the investor to analyse the total maximum loss and extent of risk undertaken by investing in a particular asset or fund or company.

  6. Companies to list down the key performance indicators for their specific industry in their financial reports.

Stage 2: -

As stated in the article the following can be listed down under as substantive issues:-


Credit rating agencies and the subprime crisis

Credit rating agencies played an important role at various stages in the subprime crisis. They were highly criticized for understating the risk involved with new, complex securities that fueled the United States housing bubble, such as mortgage-backed securities (MBS) and collateralized debt obligations (CDO)


Impact on the crisis

Creditrating agencies are now under scrutiny for giving investment-grade, "money safe" ratings to securitization transactions (CDOs and MBSs) based on subprime mortgage loans. These high ratings encouraged a flow of global investor funds into these securities, funding the housing bubble in the U.S. These mortgages could be bundled into MBS and CDO securities that received high ratings and therefore could be sold to global investors. Higher ratings were believed justified by various credit enhancements including over-collateralization credit default insurance, and equity investors willing to bear the first losses. The rating agencies were one of the key culprits.They were the party who resulted in the alchemy that converted the securities from F-rated to A-rated. The complex ratings as stated by the rating agencies AAA ratings, without which the demand for these securities would have been considerably less.


Competitive pressure to lower rating standards

The rating companies earned as much as three times more for grading these complex products than corporate bonds, their traditional business. Rating agencies also competed with each other to rate particular MBS and CDO securities issued by investment banks, which critics argued contributed to lower rating standards.


Conflicts of interest

Conflicts of interest were involved, as rating agencies were paid by the firms that organize and sell the debt to investors, such as investment banks.


Rating actions during the crisis

Rating agencies lowered the credit ratings on $1.9 trillion in mortgage backed securities from Q3 2007 to Q2 2008, another indicator that their initial ratings were not accurate. This places additional pressure on financial institutions to lower the value of their MBS. In turn, this may require these institutions to acquire additional capital, to maintain capital ratios. If this involves the sale of new shares of stock, the value of existing shares is reduced. In other words, ratings downgrades pressure MBS and stock prices lower.


Corporate Financial Reporting and Objectives:-

In financial auditing of public companies in the United States, SOX 404 top-down risk assessment (TDRA) is a financial risk assessment performed to comply with Section 404 of the Sarbanes-Oxley Act of 2002 (SOX 404). The term is used by the U.S. Public Company Accounting Oversight Board (PCAOB) and the Securities and Exchange Commission (SEC).

Qualitative or quantitative risk factors govern the scope of the SOX404 assessment effort and determine the evidence required. Key steps include:

  1. identifying significant financial reporting elements (accounts or disclosures)

  2. identifying material financial statement risks within these accounts or disclosures

  3. determining which entity-level controls would address these risks with sufficient precision

  4. determining which transaction-level controls would address these risks in the absence of precise entity-level controls

  5. determining the nature, extent, and timing of evidence gathered to complete the assessment of in-scope controls

Objective of these financial statements

The framework states that the objective of financial statements is to provide information about the financial position, performance and changes in the financial position of an entity that is useful to a wide range of users in making economic decisions, and to provide the current financial status of the entity to its shareholders and public in general. The same was found wanting in case of most firms during the period of credit crisis.


Qualitative characteristics of financial statements

The Framework describes the qualitative characteristics of financial statements as having

  • Understandability

  • Relevance

  • Reliability &

  • Comparability

  • Accountability

  • Timeliness

The core of the problem was the failure of many companies to provide a complete and an acurate depiction of their financial standing.


IAS 36: Objective: Valuation of Impaired Assets.

Objective

To ensure that assets are carried at no more than their recoverable amount, and to define how recoverable amount is determined.


Valuation Process:

At each balance sheet date, review all assets to look for any indication that an asset may be impaired (its carrying amount may be in excess of the greater of its net selling price and its value in use). IAS 36 has a list of external and internal indicators of impairment. If there is an indication that an asset may be impaired, then one must calculate the asset's recoverable amount.

The recoverable amounts of the following types of intangible assets should be measured annually whether or not there is any indication that it may be impaired. In some cases, the most recent detailed calculation of recoverable amount made in a preceding period may be used in the impairment test for that asset in the current period

� Value in Use

The calculation of value in use should reflect the following elements:

  • an estimate of the future cash flows the entity expects to derive from the asset

  • expectations about possible variations in the amount or timing of those future cash flows

  • the time value of money, represented by the current market risk-free rate of interest

  • the price for bearing the uncertainty inherent in the asset

  • other factors, such as illiquidity, that market participants would reflect in pricing the future cash flows the entity expects to derive from the asset

Cash flow projections should be based on reasonable and supportable assumptions, the most recent budgets and forecasts, and extrapolation for periods beyond budgeted projections. Cash flow projections should relate to the asset in its current condition - future restructurings to which the entity is not committed and expenditures to improve or enhance the asset's performance should not be anticipated.

Estimates of future cash flows should not include cash inflows or outflows from financing activities, or income tax receipts or payments.


Discount Rate

In measuring value in use, the discount rate used should be the pre-tax rate that reflects current market assessments of the time value of money and the risks specific to the asset.

The discount rate should not reflect risks for which future cash flows have been adjusted and should equal the rate of return that investors would require if they were to choose an investment that would generate cash flows equivalent to those expected from the asset.


Recognition of an Impairment Loss

  • An impairment loss should be recognized whenever recoverable amount is below carrying amount.

  • The impairment loss is an expense in the income statement (unless it relates to a revalued asset where the value changes are recognized directly in equity).

  • Adjust depreciation for future periods.

Reversal of an Impairment Loss

  • Assess at each balance sheet date whether there is an indication that an impairment loss may have decreased. If so, calculate recoverable amount.

  • No reversal for unwinding of discount.

  • The increased carrying amount due to reversal should not be more than what the depreciated historical cost would have been if the impairment had not been recognized.

  • Reversal of an impairment loss is recognized as income in the income statement.

  • Adjust depreciation for future periods.

  • Reversal of an impairment loss for goodwill is prohibited.

Coclusion:

The fact that the assets were held in the balance sheet date even though no market existed for those securities was the drawback as per the accoutig reports as pulished by compaies of FASB


Electronic Financial Reporting

The Introduction of Thrift Financial Report

All regulated financial institutions in the United States are required to file periodic financial and other information with their respective regulators and other parties. Thrifts are required by the Office of Thrift Supervision or OTS, among other requirements, to file a key quarterly financial report called the Thrift Financial Report or TFR to be filed electronically with the OTS. In 2007, there had been a proposal that thrifts convert to filing a similar report, the Report of Condition and Income commonly referred to as the Call Report, which banks prepare and file with the FDIC.

The TFR contains 17 schedules, which include financial statements and supplemental information filed for the reporting savings association consolidated with its subsidiaries. Information on the TFR, including income and expense and cash flow data, is reported for the quarter, not year-to-date, with the exception of Schedule FS, Fiduciary and Related Services, in which fiduciary and related services income is reported for the calendar year-to-date. Most information on the TFR is available to the public for individual institutions; however, certain information is considered proprietary and is not released. All data are released in aggregate form.


Stage3:-

Actions taken to improve Credit rating approach

Credit rating agencies help evaluate and report on the risk involved with various investment alternatives. The rating processes can be re-examined and improved to encourage greater transparency to the risks involved with complex mortgage-backed securities and the entities that provide them. Rating agencies have recently begun to aggressively downgrade large amounts of mortgage-backed debt. In addition, rating agencies have begun taking action to address perceived or actual conflicts of interest, including additional internal monitoring programs, third party reviews of rating processes, and board updates.


Audit Quality: - Measures and Goals

Specific Goals

  • Improving public company audit quality through research and communications about current developments in public company auditing.

  • Facilitating conversation to bring market participants together to discuss improvements of the quality, relevance and integrity of financial reporting.

  • Narrowing the expectations gap between regulatory standards and public expectations by pursuing approaches that help auditors and issuers address fraudulent financial reporting through increased transparency, performance and both legislative and policy initiatives.

  • Promoting a greater understanding of independent public company auditors and the services they perform.

  • Providing public company auditing professionals' information and resources for the better practice of their profession.

Sarbanes-Oxley Section 404

The CAQ's activities also focus on research, dialogue and recommendations in respect to accounting and compliance issues raised by the Sarbanes-Oxley Act of 2002, specifically the Act's Section 404. The act is a landmark piece of legislation for market stability, and the priority placed on it by the CAQ underscores the crucial role of the profession in investor confidence and the stability of the capital markets.

Sarbanes-Oxley mandated company management to design and implement internal controls over financial reporting and required company officers to attest to the establishment and maintenance of those controls. In addition, for the first time, outside auditors for large public companies were required to provide an opinion as to management's assessment of the effectiveness of those controls.

The CAQ has been heavily engaged with the Securities and Exchange Commission and the Public Company Accounting Oversight Board as the two agencies implement the complicated regulatory framework mandated by the Sarbanes-Oxley Act. The CAQ writes public comment letters to both agencies to influence and inform the regulatory process.


The Call Report: A step towards Electronic Filing

All regulated financial institutions in the United States are required to file periodic financial and other information with their respective regulators and other parties. For banks in the U.S., one of the key reports required to be filed is the quarterly Report of Condition and Income, generally referred to as the Call Report. Specifically, every National Bank, State Member Bank and insured Nonmember Bank is required by the Federal Financial Institutions Examination Council or "FFIEC") to file a Call Report as of the close of business on the last day of each calendar quarter, i.e. the report date. The specific reporting requirements depend upon the size of the bank and whether or not it has any foreign offices. Call Reports are due no later than 30 days after the end of each calendar quarter. The FDIC is responsible for overseeing insured financial institution adherence to FFIEC reporting requirements, including the observance of all bank regulatory agency rules and regulations, accounting principles and pronouncements adopted by the Financial Accounting Standards Board (FASB) and all other matters relating to a Call Report submission. Call Reports are required by statute.

Source: Essay UK - http://turkiyegoz.com/free-essays/finance/financial-crisis.php


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