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

Diplomarbeit von Miriam Janzen

Introduction:

The Subprime Crisis 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, 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. 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.

Table of Contents:

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Clarification of Fair Value Measurement in Inactive Markets:

On October 10, 2008 the FASB issued the Staff Position FSP FAS 157-3, in order to clarify the application of FAS 157 for financial assets in inactive markets. Among other topics, this FSP clarifies that ‘For both recurring and nonrecurring fair value measurements using significant unobservable inputs (Level 3), paragraphs 32 and 33 of Statement 157 require an entity to describe the inputs and the information used to develop those inputs.” Additionally, the FSP states that a company’s own assumptions about future cash flows may be acceptable to estimate FVs as long as observable inputs are not available and the discount rate includes an appropriate risk adjustment market participants would undertake to address non-performance and liquidity risks. Additionally, the FSP insists on FAS 157 being constructed to be a principles based standard, as it clarifies that ‘Determining fair value in a dislocated market depends on the facts and circumstances and may require the use of significant judgment about whether individual transactions are forced liquidations or distressed sales.” Furthermore, the FSP clarifies that e.g. in case of a significant decline in the level and volume of trading activity in an asset, or in case of significant variability of available prices among market participants, observable Level 2 inputs might require significant adjustments, and consequently would be considered Level 3 measurements. Additionally, the FSP includes an example illustrating key considerations for determining the FV of a financial asset in an inactive market. The FSP also clarifies that its guidance is consistent with, and amplifies the guidance provided in a press release by the SEC and the FASB that has been issued some days prior to the FSP. The FSP became effective upon issuance.

When the FASB issued FSP FAS 157-3, several people interpreted the staff position as an amendment of FAS 157, which smoothes the current approach to measure FV by providing companies with more discretion or flexibility when measuring assets in illiquid markets. In the author’s opinion, such interpretations clearly go back to misinterpretations of the guidance in FAS 157. After studying the FSP FAS 157-3 and the related guidance in FAS 157, the author concludes that the guidance in the FSP is principles based and derived from the current guidance in FAS 157, i.e. it does not object or smoothen the current guidance in FAS 157. Consequently, the FSP will disappoint those market participants, who asked the FASB to smoothen FV accounting or desired more rules-based guidance either on how to measure FV pursuant to Level 3 or on the boundaries between Level 2 and Level 3 of the FV hierarchy. But, in the author’s perception, the FSP will help those market participants, who misinterpreted the guidance in FAS 157. Although, the author appreciates the issuance of FSP FAS 157-3, in her perception, instead of providing additional guidance, it might be more appropriate to rework the structure of FAS 157 and clarify the wording within FAS 157, as additional guidance will likely increase the complexity within the system of U.S. financial accounting standards. The author realizes that a change to an accounting standard takes more time than issuing an FSP. However, in her perception the guidance of FSP FAS 157-3 should subsequently be included in FAS 157 to avoid further unnecessary complexity.

Elimination of the Qualifying Special Purpose Entity Concept:

On December 6, 2007 President Bush and Treasury Secretary Paulson endorsed the so-called Streamlined Foreclosure and Loss Avoidance Framework for Securitized Subprime Adjustable Rate Mortgage Loans, developed by the American Securitization Forum (ASF). The Framework applies to certain securitized subprime ARM loans which were originated and will reset within a specific timeframe and that have an initial fixed rate period of three years or less. The goal of this framework in general is to decrease the number of foreclosures as the ASF believes that this is in the best interest of all market participants. Therefore, the ASF categorizes subprime ARM loans into three segments based on the borrowers’ actual ability to refinance. The ASF Framework encourages servicers to provide fast track loan modifications for certain so-called Segment 2 subprime ARM loans. The ASF signifies it can be presumed that borrowers having Segment 2 ARM loans, eligible for a fast track modification, will not be able to pay pursuant to the original terms of the loan, since interest rates will reset, and that default of those loans is reasonably foreseeable. Thus, in a fast track loan modification, the interest rates of these loans would be fixed for another five years since the upcoming reset date.

The Framework caused uncertainty among preparers, auditors and others, whether such modifications of Segment 2 subprime ARM loans would violate the QSPE status. Presumably because of pressure from the congress, in a letter dated January 8, 2008, the SEC`s Chief Accountant Conrad Hewitt responded to the concerns, by stating that the SEC’s OCA concluded that modifications of Segment 2 subprime ARM loans pursuant to the specific screening criteria in the ASF Framework will not object to continued status as a QSPE. Additionally, the letter clarified that the SEC expects companies to provide sufficient information in their MD&A about the impact the ASF Framework has on the employed loss mitigation strategies for subprime ARM loans held in QSPEs, and on the level of servicer discretion related to those loans. Additional disclosure guidance is provided in the letter to meet this objective.

Although FAS 140 does neither indicate whether modifying a securitized mortgage in a QSPE prior to an actual delinquency or default would be appropriate for a servicer, nor include specific accounting and disclosure guidance concerning the nature of permitted modification activities of QSPEs, loan modifications pursuant to the ASF framework do in fact stretch the QSPE concept, by undermining their rationale, as the FASB intended for QSPEs to be on autopilot, which means not being actively managed. Consequently Hewitt clarified that the SEC’s accounting and disclosures guidance is meant to be an interim ruling, and - concurrent with the SEC’s conclusion about Segment 2 modifications - the OCA requested the FASB to immediately address the matters stemming from the application of the QSPE guidance in FAS 140 and to have amendments in space becoming effective no later than by the end of year 2008.

On its April 2, 2008 Meeting, the FASB decided to completely eliminate the QSPE concept from FAS 140 and consequently delete the scope exception for QSPEs from FIN 46(R). This decision is carried forward in the ED to amend FAS 140, which was issued on September 15, 2008. The elimination of the QSPE concept seems to be mainly a consequence of the SEC’s judgement regarding loan modifications pursuant to the ASF Framework discussed above. In this context FASB chairman Herz stated that QSPEs were tolerable until recently and that in hindsight subprime mortgages were not Q-able, because of the necessity of intensive restructuring of the assets, which in his opinion should not have been allowable for QSPEs. In general the FASB thinks that the QSPE concept it is not working as they intended it to, and that it is no longer operational in practice. Arguments of the FASB members include that securitization markets have developed very fast and expanded beyond what was originally contemplated by the Board, when FAS 140 was issued, and that it would be almost impossible in the actual market to design any SPE in a way that would be consistent with what the FASB had intended, when developing FAS 140.

In the author’s opinion, the advantages of the interim decision to allow modifications of Segment 2 subprime ARM loans will overweigh the disadvantages, because many transferors rejected to modify loans before the SEC clarified that it does not violate the QSPE status. Market participants and the overall economy will profit from less foreclosure and its consequences. Moreover, the author believes that otherwise, the FASB might have never eliminated the QSPE concept, but would still deliberate, whether and how to modify it. The author supports the elimination of the QSPE concept, because she is of the opinion that it would be more appropriate to look at those as VIEs. Moreover, the author believes that the elimination of the concept will likely provide financial statement readers with more risk-relevant information and consequently enhance transparency regarding a company’s financial position. Beyond those aspects, the author is convinced that removing the QSPE concept will clearly reduce complexity within the system of U.S. financial accounting standards. Finally, a concept comparable to QSPEs is unknown by IASB’s standards and the elimination of the model is a step towards international convergence.