Effects of the Subprime Crisis on the U.S. American Financial Reporting System

Table of Contents

Table of Contents

List of Abbreviations

List of Symbols

1 Introduction

2 History of the Subprime Crisis
2.1 The Term Subprime in Context of the Crisis
2.2 Key Causes and Development of the Subprime Mortgage Boom
2.2.1 Broader Economic Factors
2.2.2 Mortgage Securitization – Volume, Process and Participants
2.3 Development of the Subprime Crisis
2.3.1 Outbreak of the Subprime Crisis and Underlying Factors
2.3.2 Confidence and Liquidity Crisis
2.4 Intermediate Results: Key Causes of the Crisis

3 U.S. Financial Reporting System – Elements and Organizations
3.1 Reporting Standards and Authoritative Organizations
3.2 Auditing Standards, Ethic Code and the PCAOB
3.3 Examinations, Enforcement and Assigned Organizations
3.4 Education and Related Organizations

4 Critical Analysis of Reporting Standards Related to the Crisis
4.1 Fair Value Measurement in Context of the Crisis
4.1.1 Scope and Acceptance of Fair Value Accounting
4.1.2 Fair Value Measurement Pursuant to FAS 157 and Related Criticism
4.1.2.1 Fair Value Hierarchy Pursuant to FAS 157
4.1.2.2 Analysis of Public Criticism Related to the Fair Value Hierarchy
4.1.2.3 Critical Review of Disclosure Requirements Pursuant to FAS 157
4.1.3 Discussion of Allegations Regarding Procyclicality
4.2 Reporting for Off-Balance Sheet Arrangements and the Crisis
4.2.1 Assessment of Accounting Concepts and Disclosure Requirements
4.2.1.1 Derecognition of Financial Assets
4.2.1.2 Characteristics of Qualifying Special Purpose Entities
4.2.1.3 Concept and Consolidation of Variable Interest Entities
4.2.1.4 Related Key Disclosure Requirements
4.2.2 Evaluation of Public Criticism

5 Critical Evaluation of Actions Taken in Consequence of the Crisis
5.1 Clarifications and Planned Amendments to Accounting Standards
5.1.1 Clarification of Fair Value Measurement in Inactive Markets
5.1.2 Elimination of the Qualifying Special Purpose Entity Concept
5.1.3 Amendments to the Derecognition Model
5.1.4 Changes to Consolidation of Variable Interest Entities
5.1.5 Proposed Disclosure Amendments to FAS 140 and FIN 46(R)
5.1.5.1 Introduction of Overall Objectives and Aggregation Principles
5.1.5.2 Selective Disclosure Amendments Regarding Derecognition
5.1.5.3 Disclosure Amendments with Respect to Variable Interest Entities
5.1.5.4 Assessment of Disclosure Amendments to FAS 140 and FIN46(R)
5.1.6 Assessment of Effective Dates with Respect to Standard Setting
5.2 Findings Regarding Auditing and Ethic Standards
5.3 Actions with Respect to Examinations & Enforcement
5.4 Educational Proceedings and Considerations
5.4.1 Advising Letters of the SEC Regarding MD&A Disclosures
5.4.1.1 Advises for Disclosures about Off-Balance Sheet Arrangements
5.4.1.2 Advises for Disclosures Concerning Fair Value Measurements
5.4.2 Educational Publications Regarding Fair Value Measurement
5.4.2.1 Individual Publications of the FASB, AICPA and PCAOB
5.4.2.2 Joint SEC and FASB Clarifications on Fair Value Accounting

6 Conclusion

Appendix and List of Appendices

List of Laws, Ordinances and Administrative Directives

List of Literature

List of Abbreviations

illustration not visible in this excerpt

List of Symbols

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1 Introduction

The Subprime Crisis¹ became noticeable first in the second half of 2006, when many subprime mortgage borrowers in the United States of America (U.S.) were no longer able to make their loan payments,² and securities linked to those mortgages, that had been sold all over the world, turned out to be often worth quite less and in general substantially more risky than market partici­pants had expected. The crisis caused several major financial institutions and mortgage lenders to face substantial liquidity problems or even to file for bank­ruptcy, and Governments to provide funding in order to limit further damage to the economy.³ As the market tried to figure out the problems underlying the crisis, financial reporting, especially regarding derecognition of financial as­sets, special purpose entities and fair value measurement, became a matter of public concern. Consequently, the purpose of this work is to discuss these con­cerns in order to estimate whether and to what extend financial reporting might have contributed to the crisis and to present and assess the usefulness of actions taken by the U.S. Financial Reporting System in response to the crisis.

In order to meet this objective, the second main chapter provides a brief de­scription of how the housing boom and the subsequent crisis evolved. The in­formation provided therein shall contribute to the reader’s understanding with respect to the following passages and especially judgements made by the au­thor regarding the role of financial reporting in the crisis. The third main chap­ter will describe the U.S. Financial Reporting System, by providing basic in­formation about U.S. institutions that authoritatively deal with the elements of the system, including their aims, basics about their work and how they interact. The fourth main section of the paper will examine the relevant reporting con­cepts and disclosure requirements, provide suggestions for improvements, and assess concerns voiced by market participants with respect to financial report­ing. Subsequently, the thesis will analyze and judge actions taken by authorita­tive institutions of the U.S. Financial Reporting Sytems in response to the cri­sis. This thesis considered publications issued until December 10, 2008.

2 History of the Subprime Crisis

2.1 The Term Subprime in Context of the Crisis

The Crisis is based on mortgage loans given to subprime borrowers.⁴ A mort­gage loan is the amount of money a borrower owes on a mortgage. Thereby a mortgage is a lien on real estate given as collateral for the loan, i.e. if the bor­rower fails to repay the mortgage loan the lender has the right to take posses­sion of the property.⁵ Subprime mortgages are mortgages taken by subprime borrowers. Basically, a borrower who is designated subprime, is a person who does not qualify for prime (mortgage) loans.⁶ There is no unique precise defini­tion determining the subprime status of a borrower,⁷ but in general such bor­rowers usually feature a weak credit history, or other characteristics associated with a higher risk of default compared to non-subprime borrowers.⁸ Therefore, these loans carry higher interest rates⁹ and higher fees,¹⁰ than prime mortgages. Although lacking a unique definition of subprime, there is no doubt about the huge growth of the subprime mortgage market in recent years.¹¹ While in 1994 less than 5% of mortgage originations were subprime, the share was about 20% in 2006.¹²

Some kinds of mortgages that played a substantial role during the housing boom (and the subsequent crisis) were hybrids of so-called Adjustable Rate Mortgages (ARMs). These hybrids carry a fixed interest rate for an initial payment period. After this initial period has passed, the interest rate adjusts in a pre-arranged frequency¹³ according to an index plus margin.¹⁴ The standard subprime mortgages are 2/28 and 3/27 ARMs¹⁵, which means that the interest rate is fixed for the first 2 or 3 years, and then adjusts to an index plus margin for the following 28, 27 years respectively.¹⁶ In 2005, about 80% of all sub-prime mortgage loans originated were ARMs.¹⁷

2.2 Key Causes and Development of the Subprime Mortgage Boom

2.2.1 Broader Economic Factors

In order to stimulate the economy after the collapse of the so-called internet-bubble, the Federal Reserve (Fed) increased the money supply, i.e. liquidity in the U.S. economy,¹⁸ by lowering the Federal Funds Rate (FFR) through open market operations¹⁹ continuously from 6.5% which was valid until January 2001 to 1% in June 2003.²⁰ The intention of low FFR is to encourage borrow­ing, which should vivify spending and investing.²¹ In coherency with the low­ering of Federal Funds Rates (FFR), authors blame the FED for the decrease of mortgage rates to historically low levels²² and consequently for increasing the demand for (subprime) mortgages significantly.²³ Because banks suffered losses from the bust of the internet bubble and the subsequent recession during the years 2000 to 2002, many of the large commercial banks changed their strategy and focussed on retail banking, including subprime mortgage bank-ing.²⁴ Additionally, owning a house is part of the American dream, as people believe that homeownership entails all kinds of virtues²⁵ and “The idea that spending was 'patriotic' was widely propagated...”.²⁶ Although the average percentage interest rate on subprime mortgages was about 4 to 6 percentage points above the average percentage interest rate on prime mortgages with comparable maturity, the average interest rate on subprime mortgages was well below that on credit card borrowing. Therefore, the subprime mortgage market was the cheapest source of credit for millions of potential borrowers.²⁷

Another factor that amplified the subprime mortgage boom was the increase of house prices. The price of an average house in the U.S. rose from $170,000 in 2000 to $240,000 in 2005. The reason for this increase is most probably, that more and more people were able to finance a home by taking out mortgages. This in turn led to a feedback on subprime mortgage lending, ²⁸ because market participants thought that in case of payment delinquencies (e.g. because of higher interest rates after the intitial fixed period of ARMs expired), borrowers could refinance their mortgages by increasing their mortgage loans based on the increased worth of their houses, or sell the house at the increased price and repay the mortgage.²⁹

2.2.2 Mortgage Securitization – Volume, Process and Participants

Mortgage lenders usually did not hold the individual mortgages they issued on their own books. Instead, these mortgages were usually securitized and sold to investors in the securities market.³⁰ Securitization played an important role in the subprime mortgage market, as about 75% of subprime mortgages origi­nated in 2006 have been securitized. This means approximately $450 billion of originated subprime mortgages in 2006 were ultimately funded by investors in subprime-linked securities.³¹ Furthermore, nearly 75% of all securitized sub-prime mortgages originated during 2004 and 2005 were 2/28 and 3/27 ARMs.³²

The typical securitization process of (subprime) mortgages can be described as follows. Mortgage lenders collect (subprime) mortgages, which are then trans­ferred to special-purpose-entities (SPEs), either by the lender itself or by an­other financial intermediary the lender previously sold the mortgages to.³³ The SPE then becomes the owner of the mortgages.³⁴ If the transfers meet the con­ditions for sale accounting, the mortgages will be derecognized from the trans-feror’s balance sheet. For accounting purposes, these SPEs might be con­structed either as QSPEs or as VIEs. Depending on the type of SPE and other circumstances those SPEs are not consolidated by any party involved with it.³⁵ A servicing company collects the loan payments from the mortgage borrowers and passes them forward to the SPE in exchange for a fee, and handles delin­quent loans and foreclosures.³⁶ The servicer may e.g. be the party, which trans­ferred the assets to the SPE.³⁷ The SPE issues so-called mortgage backed secu­rities (MBS), which are securities directly backed by pools of (subprime) mort­gages previously transferred to the SPE.³⁸ MBS are debt instruments,³⁹ which entitle their buyers to receive the cash flow generated by the mortgages.⁴⁰ Be­fore the MBS are sold to investors in the securities market, the MBSs are tranched and rated by a rating agency. The ratings typically range from AAA, - which is the best rating and reflects the highest investment grade - down to AA, A, BBB and so forth. Thereby, the ratings reflect the probability of default.⁴¹ However, the ratings are de-linked from the credit risk of the individual mort-gages,⁴² as the MBS are not backed by specific loans.⁴³ Instead, the ratings de­clare how the securities rank regarding the right to receive cash flows and the obligation to absorb losses from the pool of mortgages underlying the securi-ties.⁴⁴ Often, Subprime MBS rated AA or lower are re-securitized into so-called collateralized debt obligations (CDOs), which again are tranched and rated. As in the MBS securitizations, the most senior CDO tranche obtains an AAA rat-ing.⁴⁵ CDOs may again be re-securitized several times resulting into so-called CDO2, CDO3, etc.,⁴⁶ resulting in even higher complexity of those products.⁴⁷ Because of the optimism about the performance of subprime mortgages, more than 90% of securities linked to this market got an AAA rating.⁴⁸ Investors in securities linked to the subprime mortgage market often failed to perform due diligence on their investments, and instead relied on these ratings provided by agencies.⁴⁹ Those Investors include commercial banks, investment banks and investment companies such as mutual and hedge funds, pension funds and in­surance companies.⁵⁰ Thereby, Investors may be transferors as well.⁵¹

Further contributing to the complexity in the securitization market, transferors or third-parties were involved in the securitization process through several kinds of commitments and guarantees.⁵² An example that acquired significant attention by the government⁵³ and the press⁵⁴ were so-called liquidity puts, which are derivative instruments. In case of Citigroup, which provided such puts, those guaranteed to pay back the investment at original value,⁵⁵ plus in­terest, with few exceptions.⁵⁶ Because of these puts, the CDOs obtained the same investment grade as the put provider.⁵⁷ Another example is loan repur­chase obligations. Those were usually provided by market participants who transferred assets to a SPE, and guaranteed to buy back mortgages from the SPE in the event of early payment defaults of the mortgage borrowers.⁵⁸ Fur­thermore, the transferors or banks guaranteed to provide liquidity support to SPEs, in case the securities issued have a shorter life than the underlying assets –which is usually true for securities backed by mortgages - and thus must be rolled-over, i.e. reissued, after a certain time. The liquidity support agreements (e.g. letters of credit) guarantee to provide financing if the securities cannot be rolled-over.⁵⁹ At times house prices increased, interest rates were low and fore­closure activities appeared infrequently and uncorrelated among each other, subprime mortgage related securities performed well,⁶⁰ and their investors and guarantors apparently did not think they were exposed to high risks.⁶¹ A figure that shows the above described positions in a typical (subprime) mortgage se-curitization is attached in Appendix I of this diploma thesis.⁶²

2.3 Development of the Subprime Crisis

2.3.1 Outbreak of the Subprime Crisis

In response to the reviving of the US economy, the Fed began to increase FFR stepwise from 1% in June 2004 to 5.25% in June 2006, which remained valid until September 2007.⁶³ Especially the borrowers of 2/28 and 3/27 subprime ARMs faced problems in making their payments, since the initial fixed interest rate period ended and their mortgages reset to higher interest rates, which was often an increase of 30% or more.⁶⁴ Additionally, new home sales stagnated by the middle of 2006,⁶⁵ and house prices in the U.S. declined in average by 16.3% between July 2007 and July 2008,⁶⁶ presumably partly because of the growing foreclosure activities. Because many borrowers could only afford their mortgage if house prices continue to increase, i.e. allowing them to refinance, the house price depreciation forced even more borrowers into foreclosure.⁶⁷

In the second half of 2006, so called early payment defaults - this means bor­rowers were not even able to make their first several payments⁶⁸ - increased significantly,⁶⁹ indicating a weakening of lending practices in 2006.⁷⁰ Thereby, the majority of foreclosure on subprime mortgages related to ARMs. The huge increase of early payment defaults contributed to several mortgage lenders tak­ing unanticipated high expenses,⁷¹ e.g. as a consequence of loan repurchase obligations.⁷² By April 2007, more than 20 subprime lenders had filed for bankruptcy.⁷³ After all, the number of foreclosure fillings on subprime ARM loans increased by 90% in the second quarter of 2007 from the same quarter one year prior.⁷⁴

2.3.2 Confidence and Liquidity Crisis

Market participants grew concerned about the decline of house prices and the rising level of credit losses, which they feared to increase for the foreseeable future.⁷⁵ Moreover, as foreclosure grew, subprime-linked securities were down-rated several degrees (e.g. about 45 per cent from single A to single B or less⁷⁶) from the mid of 2007,⁷⁷ which concussed investors’ faith in the reliabil­ity of ratings.⁷⁸ More or less over sudden, assets like CDOs appeared far less attractive to investors,⁷⁹ and market participants grew far more risk-avers re­garding subprime-linked products.⁸⁰ Ultimately, most markets for subprime-linked securities dried up completely,⁸¹ as market participants were no longer willing to transact. SPEs became unable to reissue their securities, causing the parties which agreed to provide liquidity support to fund.⁸² The liquidity put providers had to fulfil their obligations too,⁸³ and additionally, some firms vol­untarily brought formerly sold assets back onto their balance sheets, e.g. for reputational risk reasons or to avoid assets being dumped in the market.⁸⁴ The possibility of voluntary support led to further uncertainty among market par-ticipants.⁸⁵ Financial reporting with respect to SPEs and derecognition of fi­nancial assets became a matter of public concern.⁸⁶ For example, it has been stated that financial reporting did not reflect economic reality,⁸⁷ and that inves­tors stayed away, because it was ostensibly unclear to them, which companies would ultimately own the potential losses.⁸⁸

Financial institutions had to report massive write-downs,⁸⁹ because many prod­ucts linked to the suprime mortgage market have to be reported at fair value (FV), which usually represents the transaction price of an asset. The accounting concept became a centre of controversial discussions, with opponents of the accounting concept asserting that FV accounting exacerbated the crisis by gen­erating adverse feedback effects, while defendants of the accounting concept are convinced that it solely reflects market conditions.⁹⁰

Liquidity strains of financial intermediaries arose at both ends of the loan pro­duction line. On the one end, they had to keep loans that were planned on sell­ing, while on the other end, they had to honor their loan commitments. More­over, as banks’ ability to fund themselves in the secondary market became stressed, they started hoarding liquidity. They grew more reluctant to lend each other money and significantly reduced the lending periods.⁹¹ The result of these factors “... was unprecedented illiquidity in the interbank markets.”⁹² Increased risk aversion, uncertainty about the macroeconomic outlook, the soundness of financial institutions, the quality of subprime linked products and market illiq­uidity seemingly fed one another.⁹³ Ultimately, several financial institutions faced drastic liquidity problems during the crisis.⁹⁴

2.4 Intermediate Results: Key Causes of the Crisis

As the paper indicated, many aspects have contributed to the crisis and some­times reinforced each other. After all, the author is of the opinion that the boom in the subprime mortgage market was ultimately caused by systematic mis­judgement of risks - e.g. credit risk and its development in changing economic circumstances - by market participants,⁹⁵ and that the subsequent crisis was in substance an unavoidable consequence of this boom. Thereby uncertainty among market participants, e.g. about future macroeconomic developments and as a result of the extraordinary complexity and intransparency in several areas of the market - such as the complexity inherent to CDOs or arising from the complex network of interconnections within the financial system - obviously amplified the crisis.⁹⁶

3 U.S. Financial Reporting System – Elements and Organizations

3.1 Reporting Standards and Authoritative Organizations

Financial accounting and reporting standards govern the preparation of finan­cial reports and are essential to the functioning of the economy.⁹⁷ At present, authoritative accounting and reporting standards for publicly held companies are set by two organizations - the Securities and Exchange Commission (SEC) and the Financial Accounting Standards Board (FASB)⁹⁸. Primarily, pursuant to the Securities Exchange Act of 1934, it is the SEC that has statuary authority to establish the above mentioned kinds of standards, but in 1973 the SEC passed this authority to the FASB.⁹⁹

The FASB’s mission is to develop and improve financial accounting and re­porting standards in order to provide guidance and education to preparers, audi­tors and users of financial statements.¹⁰⁰ Binding promulgations of the FASB include: Statements of Financial Accounting Standards (FAS), FASB Interpre­tations (FIN) and FASB Staff Positions (FSP).¹⁰¹ FAS cover regulations for single accounting issues, FIN explicate and supplement certain FAS, and FSP represent appliance guidelines for preparers. ¹⁰² In coordination with the FASB, the Accounting Standards Exchange Commission (AcSEC), which is a working group of the American Institute of Certified Public Accountants (AICPA), pub­lishes appliance guidelines, called Statements of Position (SOP),¹⁰³ which are deemed to fall just behind FAS and FIN in authority.¹⁰⁴

In its standard-setting-process, the FASB considers the opinion of many other experts and interested persons, especially in major projects¹⁰⁵ “... to ensure that various points of view on the issues involved are represented.”¹⁰⁶ The FASB’s standard-setting process is carried out in several steps and can be described as follows:¹⁰⁷

1. Project requests and recommendations received from various sources are discussed at a public meeting and added to the agenda, if considered being significant,
2. FASB Staff members identify and analyze significant issues, which the FASB Board members deliberate in its public board meetings;
3. Issuance of an Exposure Draft (ED),
4. Public hearing on ED,
5. Evaluation of public responses and re-deliberation of proposed provi­sions at public meetings,
6. Issuance of the final FAS or FIN through simple majority vote.

Perhaps the FASB’s most important overall project is to achieve convergence with the International Accounting Standards Board (IASB) through a single set of high-quality accounting standards.¹⁰⁸ The IASB’s standard setting approach is rather principles-based, while the FASB’s approach of setting standards is mainly rules-based. Instead of detailed rules, principles-based accounting pro­vides a conceptual basis for preparers of financial statements to follow.¹⁰⁹ It is deemed that the FASB will try to become US accounting more principles-based.¹¹⁰

The SEC has been established by the Securities Exchange Act of 1934 and is only subject to supervision of the Congress.¹¹¹ The SEC`s mission “... is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”<sup>112</sup> The SEC usually relies on the FASB concerning the de velopment of accounting and reporting standards.<sup>113</sup> Nevertheless, the FASB is subject to the SEC’s oversight.<sup>114</sup> The SEC monitors<sup>115</sup> and sometimes influ­ences the FASB’s work. For example, the SEC sometimes prods the FASB to develop standards regarding specific issues,<sup>116</sup> or to take quicker action on cer­tain reporting problems.<sup>117</sup> Furthermore, the standards developed by the FASB have to be indorsed by the SEC, in order to become effective.<sup>118</sup> Even though the SEC passed some of its authority to the FASB, one of the major tasks of the SEC concerning reporting standards is the establishment of formal require­ments regarding the content of financial statements. One of the most important standards of the SEC is regulation S-K.<sup>119</sup> Furthermore, the SEC established so-calledFormswhich direct the formal structure and content of the different kinds of reports, <sup>120</sup> such as Form 10-K, that guides the preparation of the an­nual report and requires disclosures about additional material information.<sup>121</sup> The annual report on Form 10-K includes the audited financial statement and supplemental information that provide a comprehensive overview of the com­pany's business and financial condition.<sup>122</sup> Probably one of the most important elements of Form 10-K is the Managements Discussion and Analysis (MD&A), which includes the narrative explanation of financial condition and results of operation pursuant to the requirements of Item 303 of regulation S-K.<sup>123</sup> In general, Item 303 of Regulation S-K requires companies to discuss any trends, commitments, events, uncertainties and off-balance sheet arrangements that are reasonably likely to have a material impact on the company`s liquidity, capital resources and results of operations.¹²⁴

3.2. Auditing Standards, Ethic Code and the PCAOB

Auditors examine financial statements to reassure investors that financial statements are reliable, i.e. accurate, truthful, complete and prepared in compli­ance with authoritative accounting and reporting standards.¹²⁵ In general, audit standards are rules, auditors have to comply with, when performing audits. Ethic standards govern the conduct of auditors.

Establishing authoritative audit and ethic standards is one of the responsibilities of the PCAOB. This organization was built by the Sarbanes-Oxley Act (SOX),¹²⁶ which assigned the PCAOB to develop those standards.¹²⁷ In order to legally prepare or issue audit reports on publicly held companies, or to par­ticipate in such audits, audit firms have to register with the PCAOB¹²⁸ and are therewith subject to the PCAOB’s authority.¹²⁹ The Mission of the PCAOB’s oversight is to protect the public interest in the preparation of fair, informative and independent audit reports.¹³⁰ Similar to the FASB, the PCAOB states that “... it recognizes that the development of such standards should be an open, public process in which investors, the accounting profession, the preparers of financial statements, and others have the opportunity to participate.”¹³¹ The PCAOB is subject to the SEC`s supervision¹³² As with FASB, final standards proposed by the PCAOB have to be approved by the SEC. Otherwise, they do not become effective.¹³³

3.3 Examinations, Enforcement and Assigned Organizations

Enforcement is needed to foster compliance and consequently to enhance the quality and reliability of financial statements. The PCAOB is authorized to investigate audits performed by registered public accounting firms and to take disciplinary actions against those firms and associated persons, in case they violated authoritative rules related to their profession.¹³⁴ In its investigation program, the PCAOB follows a risk-based approach.¹³⁵ Possible sanctions of the PCAOB range from monetary penalties up to revocation of an audit firm’s registration.¹³⁶

Financial reporting builds one part of the SEC’s enforcement areas.¹³⁷ As the PCAOB, the SEC also deals with audit enforcement as it may e.g. suspend auditors from practicing before it in case of improper professional conduct.¹³⁸ Hence, once again it is the SEC that possesses the ultimate authority. The SEC initiates investigations into possible violations of securities law and conducts civil actions and administrative proceedings. In order to take civil actions, the SEC files a complaint with a federal court. Administrative actions proceed within the SEC before an administrative law judge. Sanctions range from in­junctions and monetary penalties up to imprisonment in case a person violates the order of the court. The Division of Enforcement (DoE) assists the SEC in executing its law enforcement. Information about possible violations of securi­ties law are brought to the DoE e.g. through investor complaints, self-regulatory organizations or media reports. Furthermore, the DoE is supported by most of the other Divisions and Offices of the SEC, as e.g. the Division of Corporation Finance (DoCF) and the Office of the Chief Accountant (OCA). The DoCF regularly reviews the disclosures of publicly-held companies, in­cluding those provided in annual and quarterly filings (i.e. forms 10-K and 10­Q) and annual reports to shareholders, in order to monitor whether companies complied with disclosure requirements and to improve the quality of disclo-sures.¹³⁹ In conducting its reviews, the DoCF focuses on areas of potential risk.¹⁴⁰ Financial Statements of public companies are reviewed at least once every three years. Disclosures of the largest public companies are reviewed more frequently by this Division.¹⁴¹ Furthermore, the OCA “...is often called upon to assist in addressing issues that arise in the context of Commission en­forcement actions.”¹⁴²

3.4 Education and Related Organizations

The rules discussed before have to be understood by preparers of financial statements and auditors, to avoid non-fraudulent compliance problems and to provide financial statement readers with reliable information. All of the organi­zations presented before do somehow contribute to Financial Reporting related Education. For example, if the SEC comments on financial reporting standards without amending them, or asks registrants to improve their financial reporting without taking enforcement actions, this may be regarded as educational ac­tions. According to the FASB’s mission, it contributes to the education of pre­parers, auditors and users of financial statements through its approach of set­ting standards.¹⁴³ Furthermore, the FASB e.g. sometimes issues papers, calledUnderstanding the Issues.¹⁴⁴ The PCAOB e.g. sometimes issues so-calledStaff Audit Practice Alerts, which “...highlight new, emerging, or otherwise note­worthy circumstances that may affect how auditors conduct audits under the existing requirements of PCAOB standards and relevant laws.”¹⁴⁵ Additionally, the AICPA is engaged in the education of Accountants.¹⁴⁶ Among others, it responsible for the Certified Public Accountant (CPA) exam,¹⁴⁷ and its Centre for Audit Quality (CAQ) regularly publishes so-called CAQ Audit Practice Alerts,¹⁴⁸ to keep its readers informed on current financial reporting related matters.

4 Critical Analysis of Reporting Standards Related to the Crisis

4.1 Fair Value Measurement in Context of the Crisis

4.1.1 Scope and Acceptance of Fair Value Accounting

Many assets that played a role during the subprime crisis have to be measured at fair value (FV). Those which are reported at FV on the balance sheet include e.g. securities classified as trading or available-for-sale (AFS), derivative in­struments, financial instruments (FI) within the scope of FAS 159 for which the fair value option is chosen and usually the initial recognition of a guaran-tee.¹⁴⁹ Unrealized gains and losses as a result of FV measurement have to be reported either on the income statement (e.g. trading securities and FI where the FV option is elected) or in other comprehensive income (e.g. AFS securi­ties, except in case of impairment).¹⁵⁰ Additionally, some assets have to be written-down to FV as a consequence of non-temporary impairment, like e.g. AFS and held-to-maturity securities.¹⁵¹

Apparently, the majority of market participants in the US¹⁵² – and as well in Europe¹⁵³ – favour the use of fair value, if markets are liquid. Some market participants plenary support the current approach for measuring FV, arguing that it provides more useful information to investors than alternative account­ing models.¹⁵⁴ Sometimes, FV accounting is even regarded as a part of a busi­ness control system,¹⁵⁵ or early warning system,¹⁵⁶ as changes in FV reflect changes in the market. In a survey of the Chartered Financial Analyst (CFA) Institute in March 2008, 79% of the 2,006 respondents indicate that the use of FV improves transparency and contributes to investor understanding of finan­cial institutions risk profiles. Another 74% are of the opinion that FV improves market integrity. Nevertheless, 55% believe that FV exacerbated the crisis.¹⁵⁷ The CFA indicates that this might eventually be a consequence of the views widely reported media.¹⁵⁸

4.1.2 Fair Value Measurement Pursuant to FAS 157 and Related Criticism

4.1.2.1 Fair Value Hierarchy pursuant to FAS 157

Although FV existed for about 50 years in the US,¹⁵⁹ interestingly, the in­creased use of market prices to measure securities since 1993 is mainly a result of the U.S. savings and loan crisis, in which losses on loans had been hidden artificially by the use of historic cost accounting.¹⁶⁰ The following text will explain FV measurement pursuant to FAS 157. This standard, entitledFair Value Measurements, was issued in September 2006, and became effective for fiscal years beginning after November 15, 2007,¹⁶¹ i.e. during the crisis. Men­tionable, FAS 157 does not create new uses for FV, i.e. it applies to those products already required to be measured at FV.¹⁶² Instead, it is designed to clarify existing standards¹⁶³ and demands more rigor from companies in esti­mating FV.¹⁶⁴ Beneath providing a unique definition of FV, FAS 157 further­more establishes a framework for measuring FV and requires companies to expand their disclosures about those measurements.¹⁶⁵

Par. 5 of FAS 157 defines fair value as “...the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”¹⁶⁶ Pursuant to par. 7, the term price refers to anexitprice from the perspective of a market participant that holds the asset or owes the liability. An orderly transaction is a transaction that is unforced, i.e. it is not a forced liquidation or distress sale.¹⁶⁷ However, sig­nificantly decreased transaction volumes do not necessarily indicate that these represent distressed or forced sales.¹⁶⁸ The SEC requires companies to provideconvincing evidencethat market prices (i.e. observable transactions) are driven by forced sales.¹⁶⁹

FAS 157 distinguishes between observable and unobservable inputs to measure FV. Pursuant to par. 21, the term input in general refers to assumptions market participants would perform in pricing the relevant assets or liabilites, including assumptions about risk, as e.g. the risk inherent in valuation techniques and /or risks inherent in the inputs to the valuation techniques used to measure FV. Thereby, observable inputs reflect those assumptions based on market data, while unobservable inputs represent the reporting company’sownassumptions about assumptions market participants would consider for pricing the asset or liability. In performing FV measurements, companies shall maximize their use of observable inputs and consequently minimize the use of unobservable in-puts.¹⁷⁰

The following FV hierarchy groups the inputs to measure FV from highest to lowest priority.¹⁷¹ Pursuant to par. 24, Level 1 inputs are unadjusted quoted prices in active markets for identical assets or liabilities. A market is deemed active, if transactions occur with frequency and volume that is sufficient to provide ongoing pricing information.¹⁷² Level 2 inputs are inputs which are directly or indirectly observable. Those include quoted market prices forsimi­larassets or liabilities in markets being active, quoted prices for similar or identical assets and liabilities in markets with few transactions and observable inputs other than quoted prices, like e.g. prepayment speeds or yield curves quoted at commonly intervals.¹⁷³ Thus, Level 2 inputs are hybrids of mark-to-market and mark-to-model FV. While quoted market prices for similar prod-

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¹ In the following referred to simply as the crisis.

² See BRAUNSTEIN, S. (2007); NAZARETH, A. L. (2007); RYAN S. G. (2008a), p. 20, footnote 14.

³ See e.g. BERNANKE, B. S. (2008a); BERNANKE, B. S. (2008b).

⁴ See HERZ, R. H. (2008b), p. 2f.

⁵ See GOEDE, G. W. (2002), p. 868.

⁶ See GRAMLICH, E. M. (2007), p. 17.

⁷ Definitions of subprime can vary among lenders. One popular indicator to measure a bor-rower’s creditworthiness is the so called FICO Score, which issues credit ratings based on repayment histories. Additionally, lenders consider e.g. debt-service-to-income-ratios and/or loan-to-value-ratios. Derived from: CROWE CHIZEK AND COMPANY LLC. (Ed.) (2008), p. 2; MURPHY, E. V. (2007), p. 2f.; RYAN, S. G. (2008a), p. 10; THE CENTER FOR STATISTICAL RESEARCH INC. (Ed.) (2005), p. 27.

⁸ See BERNANKE, B. S. (2007); SABRY, F. / SCHOPFLOCHER, T. (2007), p. 2.

⁹ See AVERY, B. / BREVOORT, K. P. / CANNER, G. B. (2007), p. 8; CROWE CHIZEK AND COMPANY LLC. (Ed.) (2008), p. 2; SABRY, F. / SCHOPFLOCHER, T. (2007), p. 2.

¹⁰ See GRAMLICH, E. M. (2007), p. 17.

¹¹ Ibid.

¹² See BRAUNSTEIN, S (2007).

¹³ See MCWHINNEY, J. (2005), p. 2.

¹⁴ See NIELSEN, B. (2007).

¹⁵ See GRAMLICH, E. M. (2007), p. 17.

¹⁶ See NIELSEN, B. (2007).

¹⁷ See CROWE CHIZEK AND COMPANY LLC. (Ed.) (2008), p. 3.

¹⁸ See MURPHY, R. P. (2008); PETROFF, E. (2007).

¹⁹ Open market operations is basically the selling or purchasing of previously issued U.S. treasury and federal agency securities, see FRB (2008).

²⁰ See FRB (2008).

²¹ See BARNES, R. (2007).

²² See WATKINS, M. (2007).

²³ See NAZARETH, A.L. (2007).

²⁴ See RYAN, S. G. (2008a) p. 8.

²⁵ See GRAMLICH, E. M. (2007), p. 57.

²⁶ BARNES, R. (2007).

²⁷ See GRAMLICH, E. M. (2007), p. 17.

²⁸ See WATKINS, M. (2007).

²⁹ See BRAUNSTEIN, S. (2007); GRAMLICH, E. M. (2007), p. 18.

³⁰ See NAZARETH, A. L. (2007).

³¹ See BAIR, S. C. (2007).

³² Ibid.

³³ See RYAN, S. G. (2008a), p.16f.

³⁴ See SABRY, F. / SCHOPFLOCHER, T. (2007), p. 6.

³⁵ For an in-depth discussion on consolidation of SPEs and derecognition, see chapter 4.2.1.

³⁶ See BAIR, S. C. (2007); SABRY, F. / SCHOPFLOCHER, T. (2007), p. 6.

³⁷ See SABRY, F. / SCHOPFLOCHER, T. (2007), p. 6.

³⁸ See RYAN, S. G. (2008a), p.18.

³⁹ See CROWE CHIZEK AND COMPANY LLC. (Ed.) (2008), p. 4.

⁴⁰ See CHEN, W. / LIU, C.-C. / RYAN, S. G. (2007), p. 6; SABRY, F. / SCHOPFLOCHER, T. (2007), p. 6.

⁴¹ See SABRY, F. / SCHOPFLOCHER, T. (2007), p. 6f.

⁴² See RÜGEMER, R. / MARR, B. (2008), p. 217.

⁴³ See SABRY, F. / SCHOPFLOCHER, T. (2007), p. 6.

⁴⁴ This means the AAA papers get paid preferentially, while the subordinated pieces get paid only to the extent the collateral permits and the higher rated securities are served with cash flows, see SABRY, F. / SCHOPFLOCHER, T. (2007), p. 6. The other way round, this means the so called equity tranche (which remains unrated) is the first to absorb credit losses from the mortgages. If that tranche completely fails, the tranche with the worst rating will take the in­cremental credit losses until it fails too. Then the tranche with the second worst rating bears the losses and so forth, until all credit losses are absorbed, see RYAN, S. G. (2008a), p. 17.

⁴⁵ The creation of higher-rated CDOs out of lower-rated MBS is possible as CDOs are con­structed to include diverse sets of MBS from many former securitizations. Under normal cir­cumstances, the losses on the individual MBS in the pool are expected to diversify considera­bly. Additionally, individual MBS experiencing losses in a CDO re-securitization pool do not need to fail completely, and the portion that is not lost is allocated to the most senior CDO tranche. See RYAN S. G. (2008a), p. 17f.

⁴⁶ See RYAN, S. G. (2008a), p. 18.

⁴⁷ See HERZ, R. H. (2008b), p. 4.

⁴⁸ See DODD, R. / MILLS, P. (2008).

⁴⁹ See DODD, R. / MILLS, P. (2008); IIF (Ed.) (2008b), p. 16; PETROFF, E. (2007).

⁵⁰ See CROWE CHIZEK AND COMPANY LLC. (Ed.) (2008), p. 4; similar: SABRY, F. / SCHOPFLOCHER, T. (2007), p. 7; AICPA (Ed.) (2007), p. 2.

⁵¹ See RYAN, S. G. (2008a), p. 52, figure 3.

⁵² See CROWE CHIZEK AND COMPANY LLC. (Ed.) (2008), p. 5 in conjunction with RYAN, S. G. (2008a), p. 18.

⁵³ See REED, J. (2008), p. 1f.

⁵⁴ See HENRY, D. (2007); LOOMIS, C. (2007).

⁵⁵ See LOOMIS, C. (2007).

⁵⁶ See HENRY, D. (2007).

⁵⁷ Ibid.

⁵⁸ See CROWE CHIZEK AND COMPANY LLC. (Ed.) (2008), p. 7.

⁵⁹ See RYAN, S. G. (2008a), p. 18.

⁶⁰ See NAZARETH, A. L. (2007); RYAN, S. G. (2008a), p. 14f.

⁶¹ Similar: HENRY, D. (2007), who refers to providers of liquidity puts.

⁶² See Appendix I, p. 72 of this diploma thesis.

⁶³ See FRB (2008).

⁶⁴ See BAIR, S. C. (2007).

⁶⁵ See BARNES, R. (2007).

⁶⁶ See CLIFFORD, C. (2008).

⁶⁷ See DODD, R. / MILLS, P. (2008).

⁶⁸ See NAZARETH, A. L. (2007).

⁶⁹ See NAZARETH, A. L. (2007); RYAN S. G. (2008a), p. 20, footnote 14.

⁷⁰ See BRAUNSTEIN, S. (2007).

⁷¹ Ibid.

⁷² See NAZARETH, A. L. (2007).

⁷³ See GRAMLICH, E. M. (2007), p. 8.

⁷⁴ See CENTER FOR RESPONSIBLE LENDING (Ed.) (2007), p. 3.

⁷⁵ See AICPA (Ed.) (2007), p. 1.

⁷⁶ See figure of Standard & Poor’s in: DODD, R. / MILLS, P. (2008).

⁷⁷ See DODD, R. / MILLS, P. (2008).

⁷⁸ See DODD, R. / MILLS, P. (2008); FSF (Ed.) (2008b), p. 6.

⁷⁹ See BARNES, R. (2007).

⁸⁰ See BARNES, R. (2007); FSF (Ed.) (2008a), p. 2 / p. 4.

⁸¹ See POZEN, R. C. (2008).

⁸² See NAZARETH, A. L. (2007); RYAN, S. G. (2008a), p. 21.

⁸³ Exemplarily, see LOOMIS, C. (2007), who exclusively refers to Citigroup.

⁸⁴ See IIF (Ed.) (2008a), p. 4, cipher 14; IIF (Ed.) (2008b), p.63.

⁸⁵ See TETT, G. / DAVIES, P. J. (2007).

⁸⁶ For an in-depth analysis see chapter 4.2.1.1, p. 30f. / chapter 4.2.1.3, p. 34f. / chapter 4.2.2, p. 38. See also REED, J. (2008), p. 1f.

⁸⁷ See PITTMAN, M. (2008).

⁸⁸ See POZEN, R. C. (2008).

⁸⁹ See IIF (Ed.) (2008a), p. 4, cipher 14.

⁹⁰ For an in depth discussion on FV measurement in context of the crisis, see chapter 4.1, p. 17­28 of this diploma thesis.

⁹¹ See DODD, R. / MILLS, P. (2008).

⁹² DODD, R. / MILLS, P. (2008).

⁹³ See FSF (Ed.) (2008b), p. 6.

⁹⁴ See BERNANKE, B. S. (2008b); DODD, R. / MILLS, P. (2008).

⁹⁵ For authors, who support a similar opinion, see: BRAUNSTEIN, S. (2007); FSF (Ed.) (2008a), p. 5; FSF (Ed.) (2008b), p. 5; HENRY, D. (2007); HERZ, R. H. (2008b), p. 2f.

⁹⁶ For authors, who support a similar opinion, see: BARNES, R. (2007); FSF (Ed.) (2008a), p. 2.

⁹⁷ See FASB (Ed.) (2007), p. 1.

⁹⁸ See ALVES, W. (2007), p. 14f. in conjunction with PELLENS, B. /FÜLBIER, R. U. / GASSEN, J. (2006), p. 56. One additional organization that has the formal right to develop and decree accounting policies, but did not make use of this right up to now, is the PCAOB. See ALVES, W. (2007), p. 16.

⁹⁹ See FASB (Ed.) (2007), p. 1.

¹⁰⁰ Ibid., p. 1.

¹⁰¹ See KIESO, D. E. / WEYGANDT, J. J. / WARFIELD, T. D. (2007), p. 9.

¹⁰² See ALVES W. (2007), p. 15f.

¹⁰³ See ALVES W. (2007), p.16.

¹⁰⁴ See HAYES, R. B. (1996).

¹⁰⁵ See FASB (Ed.) (2007), p. 3 in coherency with p. 6f.

¹⁰⁶ FASB (Ed.) (2007), p. 7.

¹⁰⁷ See FASB (Ed.) (w.y).

¹⁰⁸ See FASB (Ed.) (2008a).

¹⁰⁹ See SHORTRIDGE, R. T. / MYRING, M. (2004).

¹¹⁰ See SEC (Ed.) (2008f), time 1:04:10 – 1:04:15, respondent: Mallett III, R. B.

¹¹¹ See PELLENS, B. / FÜLBIER, R. U. / GASSEN, J. (2006), p. 58.

¹¹² SEC (Ed.) (2008d).

¹¹³ See KIESO, D. E. / WEYGANDT, J. J. / WARFIELD, T. D. (2007), p. 7; KPMG (Ed.) (2003), p. 7.

¹¹⁴ See SEC (Ed.) (2008d).

¹¹⁵ Ibid.

¹¹⁶ See KIESO, D. E. / WEYGANDT, J. J. / WARFIELD, T. D. (2007), p. 7; PELLENS, B. / FÜLBIER, R. U. / GASSEN, J. (2006), p. 65.

¹¹⁷ See KIESO, D. E. / WEYGANDT, J. J. / WARFIELD, T. D. (2007), p. 7.

¹¹⁸ See PELLENS, B. / FÜLBIER, R. U. / GASSEN, J. (2006), p. 65.

¹¹⁹ See ALVES W. (2007), p. 15.; KPMG (Ed.) (2003), S. 7.

¹²⁰ See ALVES W. (2007), p. 14f.; KPMG (Ed.) (2003), S. 7.

¹²¹ See FORM 10-K, rule C1 and C3.

¹²² See SEC (Ed.) (2006).

¹²³ See ALVES, W. (2007), p. 210.

¹²⁴ See REGULATION S-K, ITEM 303(a)(1)-(a)(3)(ii) and Item 303(a)(4)(i).

¹²⁵ See SEC (Ed.) (2008e).

¹²⁶ See SOX, section 101(a).

¹²⁷ See SOX section 103(a).

¹²⁸ See SOX, section 102.

¹²⁹ See PCAOB (Ed.) (w.y. (c)).

¹³⁰ See PCAOB (Ed.) (w.y. (c)).

¹³¹ PCAOB (Ed.) (w.y. (a)).

¹³² See PELLENS, B. / FÜLBIER, R. U. / GASSEN, J. (2006), p. 60; SEC (Ed.) (2008d).

¹³³ See PCAOB (Ed.) (w.y. (a)).

¹³⁴ See PCAOB (Ed.) (w.y. (b)); PCAOB RULES ON INVESTIGATIONS AND ADJUSTICATIONS (2003), prefix, p. 2, cipher A.

¹³⁵ See COX, C. (2008), Memorandum, p. 4.

¹³⁶ See PCAOB (Ed.) (w.y. (b)).

¹³⁷ See SEC (Ed.) (w.y.); PELLENS, B. / FÜLBIER, R. U. / GASSEN, J. (2006) p. 71.

¹³⁸ SEC RULES OF PRACTICE AND RULES ON FAIR FUND AND DISGORGEMENT PLANS (2006), rule 102(e)(1)(iv).

¹³⁹ See SEC (Ed.) (2008d).

¹⁴⁰ See COX, C. (2008), Memorandum, p. 6.

¹⁴¹ See COX, C. (2008), Memorandum, p. 2.

¹⁴² SEC (Ed.) (2008d).

¹⁴³ See FASB (Ed.) (2007), p. 1.; see also chapter 3.1, p. 11 of this diploma thesis.

¹⁴⁴ See e.g. CROOCH, G. M. / UPTON W. S. (2001), p. 1; FOSTER J. L. / JOHNSON, M. T. (2001), p. 1; HERZ, R. H. / MACDONALD, L. A. (2008), p. 1.

¹⁴⁵ PCAOB (Ed.) (w.y. (d)).

¹⁴⁶ For further information see AICPA (Ed.) (w.y.).

¹⁴⁷ See GCPAS (Ed.) (w.y.); WHITTINGTON, O. R. / DELANEY, P. R. (2007), p. 15.

¹⁴⁸ See CAQ (Ed.) (w.y.).

¹⁴⁹ For trading and AFS securities see FAS 115, par. 12; for derivatives see FAS 133, par. 17; for the scope of FAS 159 see FAS 159, par. 7f.; for FI within the scope of FAS 159 see FAS 159, par. 15; for the initial recognition of a guarantee and exceptions see FIN 45, par. 9f. - ok

¹⁵⁰ For AFS and trading securities see FAS 115, par. 13; for FI under the FV option see FAS 159, par. 3.

¹⁵¹ See FAS 115, par. 16.

¹⁵² See BASTIAN, N. et al (2008); SEC (Ed.) (2008f), time: 0:0:06 – 0:29:30; SEC (Ed.) (2008g), time: 0:05:30 – 0:06:00.

¹⁵³ See GASSEN, J. / SCHWEDLER, K. (2008), p. 2.

¹⁵⁴ See RYAN, S. G. (2008b), p. 16.

¹⁵⁵ See SEC (Ed.) (2008f), time: 0:20:07 – 0:21:15, respondent: Price, J. L.

¹⁵⁶ See FASB (Ed.) (2008e), time: 0:36:30 – 0:36:42, respondent: Schroeder, M.

¹⁵⁷ See CFA INSTITUTE (Ed.) (2008).

¹⁵⁸ See SCHACHT, K. N. / WHITE G. I. (2008), p. 3.

¹⁵⁹ See RYAN, S.G. (2008b), p. 1f.

¹⁶⁰ See DAVIES, P. J. (2008).

¹⁶¹ See FAS 157, prefix: Status.

¹⁶² See FAS 157, prefix: Summary.

¹⁶³ Before the issuance of FAS 157, the rules for FV measurement were scattered among those standards, which required the use of FV. Moreover, definitions of FV differed among stan­dards, see FAS 157, prefix: Summary

¹⁶⁴ See MILLER, P. B. W. / BAHNSON, P. R. (2007).

¹⁶⁵ See FAS 157, prefix: Summary / par. 1.

¹⁶⁶ FAS 157, par. 5.

¹⁶⁷ See FAS 157, par. 7.

¹⁶⁸ See AICPA (Ed.) (2007), p. 4.

¹⁶⁹ See RYAN, S. G. (2008b), p. 14.

¹⁷⁰ See FAS 157, par. 21.

¹⁷¹ See FAS 157, par. 22.

¹⁷² See FAS 157, par. 24.

¹⁷³ See FAS 157, par. 28.