I’m amazed at how clueless people claim to be when the piper finally takes its toll, as though risk assessment practices went unchallenged in days gone by. The truth of the matter is that many forewarned of the problems recently witnessed in the economy.I can personally point to an article I wrote titled “Risk evaluation: Just who is minding the store?” that appeared in Accounting Today (Aug. 23-Sept. 5, 1999, page 16). Among its admonitions is “that all market participants need to be assessing risks, rather than presuming the risks have been effectively shifted.”

GOVERNMENT’S ‘CONTRIBUTION’

The “hot potato” syndrome of financial instrument markets, combined with an insatiable appetite for debt, were ingredients for disaster. In both cases, the government had its hand in encouraging the components of the alleged crisis. The Long-Term Capital Management arrangement in the late 1990s involved an entity with leverage of 30-to-1. In the same time frame, leverage ratios on the order of 14-to-1 and 27-to-1 were reported to be common at banks and Wall Street investment houses.

Anyone familiar with economic cycles knows that the types of consequences now being observed were indeed inevitable when economic times begin to turn down. Yet the government’s intervention to save imprudent investment and leveraging practices sent all the wrong signals. This reality was worsened by the Federal Reserve’s action to set interest rates at their historical low levels.

Government’s encouragement of home ownership had a hand in the crisis. As the size of the Federal Home Loan Mortgage Corporation, or Freddie Mac, a quasi-governmental agency, grew, the market remaining for the private sector shrank. With less demand and ample supply, creditors competed to provide low-cost mortgages, ignoring the staid practices of the past, such as requiring substantial down payments, granting principal at 80 percent of collateral’s value.

Consider that, had purchasers saved to pay 10 percent to 25 percent of purchase price, as was once commonplace, the volatility of market values in times of economic downturns could be far more easily weathered. The problem today is the lack of investment by the homeowner, who prefers to treat the home as an option, i.e., if it goes up, it’s my gain, but if it goes down, it’s the lender’s problem.

The availability of insurance in the form of instruments such as credit derivatives like the default swap apparently lulled certain market participants into believing that their past risk-assessment practices are unnecessary. Yet the fact of the matter is that there is no such thing, in the real world, as the perfect hedge, due to systemic factors in the market place. Moreover, insurance is limited by the financial strength of the party acting as insurer. All of these realities have been borne out in the events of recent times.

ABROGATION OF CONTRACTS

A primary role of government is the protection of property rights, rather than their abrogation. Yet, a walk through the past three decades reveals an increasing tendency to abrogate rights.

In the New York City fiscal crisis of the 1970s, the rights of bondholders were abrogated, leading to larger costs of borrowing being imposed across the municipal sector. Understand that the terms of borrowing had committed those bonds to be backed by the full faith and credit of the issuer. In other words, the issuer had pledged itself to raise funds by whatever means were required, including a tax increase or sale of property, in order to honor its full faith and credit.

In the early 1980s, as the thrift industry was having problems, Freddie Mac designed a stock dividend to be distributed as a mechanism to bolster earnings and net worth. The Financial Accounting Standards Board challenged the stock dividends as not representing earnings because the thrifts already owned Freddie Mac (since they controlled the 12 regional Federal Home Loan Banks that set up that agency in 1980). Yet, succumbing to pressures, FASB permitted the income treatment.

Similar maneuvers involved revenue recognition of fee income, purchase accounting mergers’ mismatching of goodwill amortization to the life of mortgages, and the selling of loans. Regulators actively opposed adjustment in these accounting treatments by FASB, and permitted thrifts not reporting to the Securities and Exchange Commission at that time, including mutuals and locally owned stock operations, to only be subject to banks’ regulatory accounting principles that maintained old approaches to such aspects as amortization. The regulator of the savings and loans — the Federal Home Loan Bank Board — did not wish to follow FASB as it expressed hope that the passage of time would cure the ills of the thrifts’ finances. RAP was embraced over generally accepted accounting principles. The eventual cost to the taxpayer is legend.

On June 30, 1993, FASB proposed a Statement of Financial Accounting Standards, titled Accounting for Stock-Based Compensation, contending that employee stock options have value that is reasonably estimable, represents compensation, and should be recognized in the income statement. Yet the October 1995 final statement merely encouraged recognition, requiring only disclosure of compensation expense and various earnings-per-share effects. This result stemmed from government’s intent to otherwise override FASB and, in effect, close it down.

Then-SEC Chairman Arthur Levitt described in his book that his conscious persuasion of FASB to back down was his biggest mistake. Many have linked the runaway stock option practices spawned by this mistake with the dot.com era and the fallout thereafter.

Hurricane Katrina’s numerous legacies include the effects on the insurance industry that arise when contracts are abrogated. Wrong-headed proposals, such as collection of insurance premiums after the fact to cover the uninsured for their losses, demonstrate the antithesis of politics and contracts. Not only were prudent homeowners who had incurred years of insurance premiums for full coverage penalized when compared with the uninsured, but the availability and cost of coverage to current property owners are the problems spawned.

SUBPRIME LENDING

The subprime market has led to similar wrong-headed proposals and actions. Some suggest that contracts be rewritten after the fact, and ignoring the terms originally negotiated. All market participants are harmed when the contractual terms of mortgages are abrogated.

Borrowers’ payment terms are a function of the well-known five Cs of credit: capital, capacity, character, collateral and the conditions of business. When borrowers offer little or no down payment, regularly incur less interest than implied by an equivalent fixed-interest loan, and accept provisions such as early-payment penalties, the contract is priced accordingly. To bail out such terms means a slap in the face to other borrowers who prudently saved for a hefty down payment, regularly incurred the market interest, and negotiated for no early-payment penalty.

A MILE IN THEIR SHOES

If you had no money down, and the asset you had just purchased declined by 10 percent, would you choose to walk away? Presumably you care about your credit rating and would be hesitant. However, what if the government condoned your action, blaming those who extended you credit, instead of you, the imprudent borrower? Things are upside down ... as though your shoes are on your head!

The theory of “rational expectations” assumes that people take into account all available information and that influences the outcome of their decisions, that they utilize this information intelligently, and therefore that they do not systematically make mistakes. The term “systematically” means that since people will learn from past mistakes and experience, on average they cannot be consistently fooled. We learn from the past, and each of these examples demonstrates a growing expectation that contracts will be bailed out or rewritten by government intervention. No wonder the supply side of capital has waned. In their shoes, you too would be wary of investing in a contract whose terms appear as quicksand in the hands of government.

The dominance of half to three-fourths of the mortgage market by quasi-public entities belies the notion of free-market failures. Unlimited powers in the Treasury should shake any believer in checks and balances or preventive controls.

The profession should remember history as it grapples with the accounting questions proliferating as to the appropriate reflection of financial position and performance.

Wanda A. Wallace, Ph.D, is the John N. Dalton Professor of Business Emerita at the College of William and Mary. She has served on FASB’s Financial Accounting Standards Advisory Council and the Comptroller General’s Government Auditing Standards Advisory Council.

Register or login for access to this item and much more

All Accounting Today content is archived after seven days.

Community members receive:
  • All recent and archived articles
  • Conference offers and updates
  • A full menu of enewsletter options
  • Web seminars, white papers, ebooks

Don't have an account? Register for Free Unlimited Access