In 2007 when the housing market crashed the whole world was effected. Trillions of dollars have been lost and we are still trying to recover and make sense of all that took place. This economic catastrophe could have been minimized if the proper accounting practices had been followed and if the regulatory framework in place were unassailable. Alan Greenspan, in his evaluation of the housing crash stated, “.
.. the financial system would have held together, had the second bulwark against crisis-our regulatory system-functioned effectively. (Greenspan, 212)Creditors, credit rating agencies and banks were neglectful in certain areas and found loopholes in the system that eventually lead to the collapse of the financial system. One of the main issues that lead to the crash was not following the simple practice of fair value accounting.
Fair value accounting is the process of assigning a proper price to assets and liabilities (Fair Value Measurements). Often, companies who practice sound accounting have systems where financial information runs through the hands of multiple groups and people.By verifying and scrutinizing the financial information mistakes and errors can be avoided. In order to achieve higher revenues people, firms and banks misrepresented information necessary to make sound financial decisions.
Stephen G. Ryan said, “The subprime crisis was caused by firms and households making bad operating, investing, and financing decisions, managing risks poorly, and in some instances committing fraud. ” (Ryan, Stephen G. ) Aside from fraud and the misrepresentation of information, people did not follow simple rules of smart accounting.When accounting one needs to take into consideration the real amount of debt being issued and the ability of the debtor to repay that debt.
Loans were being offered to buyers of land and property with little to no effort of adequately evaluating property, houses, buildings and their fair value prices (Congleton). Loans that were not properly assessed were then offered to low income buyers who according to a simple debt to income ratio would prove to be unable to pay off such a debt.Along theses lines of unsound accounting was the practice of issuing subprime loans. This is when a loan is made to a person who the bank knows has bad credit or a higher risk of defaulting on their loan. A significant number of theses loans were secured with fraudulent misrepresentations of income. Before the housing bubble burst, profits and prosperity led banks and entities to overlook the potential threat posed by these high risk borrowers and they decided to issue the loan anyway.
Roger D. Congleton stated that, “Delinquency rates on residential real estate were exacerbated by the almost fraudulent lending practices of many loan originators, house price assessors, and some builders. Most purchasers of “negative equity” and “no docs” mortgages realized that these were relatively risky “promises” to pay for” (Congleton, pg. 300). Banks and entities overextended themselves to the point that when things started to turn south there was no recovery.
“The share of subprime mortgages to total originations increased from 9 percent in 1996 to 20 percent in 2006 according to Forbes.Subprime mortgages totaled $600 billion in 2006, accounting for approximately one-fifth of the U. S. home loan market” (Bianco). This frivolous issuance of debt fueled the ever-growing bubble that eventually did burst. While rummaging through the wreckage of the housing market crash it was discovered that off balance sheet accounting was prevalent.
Companies were storing information about assets and liabilities that were not readily visible to regulators and investors (Partnoy and Turner).Transparency is a fundamental practice of accounting that allows outsiders to have an accurate and complete financial picture of a company at a given point in time. Transparency helps assure that companies are adhering to proper accounting practices and lets investors know of any potential risks (White and Kroeker). Companies are required to remain transparent so investors may maintain confidence in the market and continue to invest. By not adhering to these regulations and policies, the housing market fell and since has not fully recovered.
