The Great Financial Crisis and the FASB

Reflection Paper: Mortgage Crisis

The mortgage crisis came about because starting in the 1990s under the Clinton Administration, a push for greater home ownership was facilitated by a lowering of lending standards for home buyer borrowers. This created artificial demand in the housing market, and prices of homes soared. Over the course of the next decade, lending standards rapidly deteriorated, and home mortgages were being bundled and sold to investors as collateralized debt obligations, and derivatives were added to the mix so that an enormous financial industry focused on mortgage-backed securities had grown into a behemoth (Lewis, 2010). The Federal Reserve had kept interest rates low in response to the Dot Com bubble bursting at the turn of the 21st century, and this in turn had caused yield-starved investors to seek out financial instruments like collateralized debt obligations. Starting in 2004, the Fed Funds Rate rose from 1% to more than 5%--a 500% increase over the course of four years from 2004 to 2008. As interest rates rose, borrowers suddenly were at risk of not being able to pay their mortgages, as they were given variable interest rates in the terms of their loans rather than fixed rates. Savvy investors had seen all of this coming in the years leading up to the housing bubble bursting, and they purchased credit default swaps (described by Michael Lewis in his book The Big Short). These swaps were like insurance on or bets against the housing bubble—and banks were all to happy to sell them to investors—until, all of a sudden, they realized they should be buying them rather than selling them (as Goldman did).

When the bubble burst—because home prices had risen too high too fast, rates were rising and borrowers were defaulting—the values of mortgage backed securities plummeted as banks like Lehman Brothers realized they had far too much risk on their books and had to divest before the market crashed: market to market accounting was being used, which meant even if assets were not liquidated their market value was still used for accounting purposes. When asset prices rose, it made firms look like they were making a lot of money. When they crashed as they did in 2008, it made firms look like they were going bankrupt.

So there really were a lot of factors that affected things. Market to market accounting was made popular by companies like Enron, but it had been made acceptable as an accounting practice when the regulatory agency, the Financial Accounting Standards Board (FASB), decided to permit fair value accounting (mark to market accounting) as an acceptable accounting practice. Had Lehman Brothers not been using fair value accounting, it probably would not have collapsed the way it did in 2008 (Young, 2008).

Putting all the blame on one institution or government agency is like putting all one’s eggs in one basket. There is enough blame to go around to all players—from AIG to Lehman to the FASB to HUD to Goldman and on down the line to borrowers who allowed themselves to be taken advantage of without asking better questions or reading into the fine print. Prior to the end of the 1990s and the start of the 2000s, buying a home required a person to have considerable savings, a good credit score, and the ability to pay the mortgage. Yet when standards were lowered to get more low-income buyers into the market in accordance with Clinton’s vision of what the market should be and how it should represent the American Dream, people did not stop to ask whether they were being boondoggled. They celebrated and rushed to get their home mortgage. Those mortgages were not kept on the books of the original lenders; they did not want that risk—so they were bundled and sold to others—and the ratings agencies, which should have paid better attention to these bundles but did not and instead rated them as AAA (which is to say as basically risk-free), were complicit in the boondoggling of investors who bought the debt.

Thus, to argue that government should regulate mortgage lending practices to prevent a similar situation from arising again is to focus only on one aspect of why the great financial crisis of 2008 happened. Regulation, oversight, and policy failed across the board. Of course, there should have been better regulation of the mortgage industry. Just like fair value accounting should have never been made acceptable by the FASB. Just like the ratings agencies never should have rated the collateralized debt obligations as AAA. Just like AIG never should have sold credit default swaps to Goldman and other buyers who realized the market was about to burst, as the Federal Reserve was raising rates. Just like the Federal Reserve never should have dropped rates in the first place in response to the Dot Com bubble of 2000; its artificial suppression of rates has been a problem from the word go—and its current (unconventional) monetary policy of quantitative easing has only helped to make sure the biggest bubble of all economic history is blown—and when it bursts, the great reset foretold to all by Klaus Schwab will finally arrive. The same stakeholders responsible for the 2008 economic crisis will be responsible for the crash to come. Lending standards may have tightened a bit since the housing bubble burst—but the introduction of QE means that the central banks can never stop serving as the buyer of last resort—because when they do all the effects of the bad policies of the past will suddenly be felt as though the dam were bursting all at once.