The Chartered Accountant

GLOBAL PERSPECTIVE
A well-functioning disclosure and regulatory environment, an infrastructure
that supports timely, accurate, and clear communications to investors, coupled
with an educated investor population, will be able to reap the benefits of
mortgage securitization and avoid the worst of the risks. Lastly, following
accounting rules, having high quality audits, making timely provisions for
bad debts, and writing down impaired assets are all old lessons but even
more critical in the new economy.
filing for bankruptcy protection in April 2007. Over
150 prime and subprime lenders also failed in 2007. 15
By 2008, the MBS themselves started to tarnish. Mortgages
had been combined into varying funds, and so
it was extremely difficult to gauge which MBS or even
which companies were susceptible to the subprime
defaults. The value of all MBS became suspect, and
just about every financial institution had some MBS
on their books. While buyers of credit default swaps
were making money, CDS sellers were taking a hit.
Soon banks were unwilling to lend to each other because
they were not sure if the other bank had a big
exposure to subprime loans and CDS. By September
2008, banks stopped lending to each other at even
high interest rates. When there is substantial risk of
the principal not being returned, a high interest rate
is not sufficient inducement for potential lenders to
part with their money. The widespread uncertainty
froze credit markets, and banks were unable to meet
their current obligations. What followed next was an
unprecedented and spectacular failure of financial institutions.
Two investment banks that were among the most
deeply leveraged in MBS were the first to go. In
March 2008, Bear Sterns was rescued by JP Morgan
Chase in a deal brokered by the New York Federal
Reserve Bank; in September Lehman Brothers, a
158-year old institution, filed for bankruptcy. After
Lehman failed, the floodgates opened on insolvencies.
Fannie Mae and Freddie Mac, which owned or
guaranteed over 50% of the $12 trillion US mortgages,
were taken over by the US government. Bank of
America stepped in to rescue Merrill Lynch. The US
Federal Reserve extended an $85 billion loan to help
AIG meet their obligations on all those credit default
swaps. That amount has since grown to $150 billion
and the eventual amount could be higher. Washington
Mutual, in the largest bank failure ever in the United
States, was seized by the Federal Deposit Insurance
Corporation (FDIC), while Wachovia bank was acquired
by Wells Fargo.
Investment banks were vulnerable to the downturn
in mortgage values for several reasons. The first was
that investment banks, unlike retail banks, do not
typically have a lot of capital. They buy and sell, borrow
and lend, making money on the transaction and
trading fees. They are not allowed to take deposits so
they depend on fee-based and trading-based income
and on loans to finance purchases and investments.
It took three to nine months to securitize the MBS,
so when the downturn came, many investment banks
were left holding warehoused mortgages that had significantly
declined in value or had no market at all. If
they had financed the purchase of those mortgages
with borrowing, they had to pay back the money they
had used to buy mortgages they could no longer sell
or securitize, creating a severe and acute cash crunch.
Adding to their difficulties, investment banks whose
client contracts required them to buy back the CDOs
that they had guaranteed scrambled for cash or credit
to meet their obligations. Investment banks were also
obligated by contract to finance several SPEs. They
had planned on raising money with short term instruments
such as commercial paper, but their access to
such credit dried up when no one was willing to lend
to a bank.
The contagion extended to traditional banks that had
MBS and CDS on their books as well. When the news
spread that banks were in financial difficulties, the loss
of confidence caused a run on several institutions,
and some in the United States and Europe became
insolvent. The ones that were solvent were anxious
to sell their MBS to meet their liquidity needs but the
MBS started trading at steep discounts, well below
the value they would realize if held to maturity. The
lack of buyers and the anxiety to sell drove the prices
of MBS down very rapidly. Mark-to-market (MtM)
accounting rules, which required firms to record the
fair market value on assets and liabilities, acted in a
pro-cyclical manner to exacerbate the decline in the
prices of MBS. John Berlau, director of the Center
for Entrepreneurship at the Competitive Enterprise
Institute and a free market proponent, likened the
MtM rules to a “method of disease transmission,”
15 Krishna Palepu, Suraj Srinivasan, and Aldo Sesia Jr., “New Century Financial Corporation,” HBS No. 109-034, (Boston: Harvard Business School Publishing, 2008).
THE CHARTERED ACCOUNTANT 1011 DECEMBER 2008