Appendix - Subprime Mortgage Crisis

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The Accounting Profession Role in the Recent Subprime Mortgage Crisis BUS 5601: Essential of Business Development 1; Professor: Brandy Havens

3/7/2011

Week #1: Discussion

Ann Reid-Shaw

The Accounting Profession Role in the Subprime Mortgage Crisis

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Table of Contents

Section 1 – Introduction ................................................................................................................... 3

Purpose & Scope ....................................................................................................................................... 3

Background ............................................................................................................................................... 3

Section 2 – Literature Review/Discussion .......................................................................................... 3

What is a subprime mortgage? ................................................................................................................. 3

What was the accounting profession role in the recent subprime mortgage crisis? ............................... 4

Section 3 – Conclusions .................................................................................................................... 5

What the accounting profession could have done differently? ............................................................... 5

Path Forward ............................................................................................................................................. 5

Section 4 - Bibliography .................................................................................................................... 6

Section 5 – Appendix: Subprime Mortgage Crisis .............................................................................. 7

Figures

Figure 1: Subprime Lending Expansion ......................................................................................................... 4

Figure 2: Subprime Mortgage Crisis – Housing Bubble Formation ............................................................... 7

Figure 3: Housing & Financial Market and Government & Industry Responses ......................................... 8

Figure 4: Subprime Mortgage Crisis – Foreclosure & Bank Instability .......................................................... 9

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Section 1 – Introduction

Purpose & Scope

A review of literature of the recent subprime mortgage crisis is examined. The

accounting profession role and recommendations on what the accounting profession could

have done differently is discussed. A brief synopsis of the causes, effects, and impact of the

subprime mortgage crisis is presented in the Appendix of this document.

Background

“No Credit, Bad Credit, Low Income, No savings – NO PROBLEM, just state your

income, apply for a loan and you can have the home of your dreams,” this approach resulted

in the recent subprime mortgage crisis. With no credit and income requirements, individuals

were seduced by the increasing housing market and took out loans they could not afford.

The subprime mortgage crisis impacted the lives of so many people including my family.

The home was purchased right before the subprime mortgage crisis and currently the home is

only worth one-third of the purchase price. Fortunately, with excellent credit and adequate

income to make the mortgage payments with ease some individuals are able to refinance the

mortgage loan and lower the monthly payments.

Section 2 – Literature Review/Discussion

What is a subprime mortgage?

A subprime mortgage is normally made out to borrowers with lower credit ratings. The

lender views the borrower as having a larger-than-average risk of defaulting on the loan

therefore the lending institutions often charge interest on subprime mortgages at a rate that is

higher than a conventional mortgage to compensate for carrying more risk.1

1 http://www.thepoliticalsword.com/post/2008/10/23/A-plain-mane28099s-glossary-of-finance-market-

terms.aspx

The Accounting Profession Role in the Subprime Mortgage Crisis

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By 2006, the subprime market had grown to 20% of the total U.S. mortgage market, and

75% of these loans were securitized and sold off to investors around the world, facilitating an

influx of capital. With credit easily available, more people than ever before were able to buy

homes.2 Figure 1 depicts the subprime lending expansion.

Figure 1: Subprime Lending Expansion

What was the accounting profession role in the recent subprime mortgage crisis?

The accounting profession contributed to the recent subprime mortgage crisis by not

applying fundamental accounting concepts, professional implementation and monitoring

principles. According to (VanDenburgh, 2008), the subprime credit market crisis nearly brought

the $28 trillion credit cycle of the U.S. business economy to a complete standstill in August

2007. There is significant blame to be shared by many other parties, including legislators,

regulators, financial firms, lawyers, bond rating companies, realtors, mortgage brokers, and

homeowners. According to (Jaffee, 2008) and other sources, subprime mortgage securitization

was the primary source of the recent mortgage crisis.

2(Yale School of Management, 2008)

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On February 29, 2008, the United States Bankruptcy Court for the District of Delaware

released a court-commissioned report, authored by Bankruptcy Court Examiner Michael J.

Missal, which detailed the failure of New Century Financial Corp., the second-largest originator

of subprime loans. Although the company had an audit committee, it did not focus on

important issues of loan quality, risk, and internal control. New Century "turned a blind eye" to

deteriorating loan standards and had "no standard for loan quality." 3 Other conditions alleged

in the Michael Missal report include:4

Borrowers’ income was not verified. No or low document loans became acceptable.

Appraisals were often deficient. Risk management was overlooked to keep business and

bonuses flowing.

Loans often had low "teaser" rates and were reset to market rates after a year or two.

Loan originations increased from $14 billion in 2002 to $60 billion in 2006. At the same

time, there was an "alarming and steady increase in early payment defaults."

Senior managers’ bonuses were tied to company performance.

Section 3 – Conclusions

Based on the literature review, this study concludes that the accounting profession

significantly impacted the recent subprime mortgage crisis by not applying fundamental

accounting concepts, professional implementation and monitoring principles to subprime

mortgage borrowers which infested the entire housing and financial market.

What the accounting profession could have done differently?

To avoid the recent subprime mortgage crisis, the accounting profession needed to:

Verify borrowers’ income. Ensure loan documentation is completed.

Review appraisals for completion. Ensure Risk Management is enforced by instituting

policies to reprimand individuals whose reckless behavior generate loses.

Establish a system in which conflicts of interest are identified and avoided.

Path Forward

Lessons learned should be applied to the current emerging economies to establish

effective policies to subprime mortgages to avoid the chaos we are currently experiencing.

If we fail to learn from history, we are doom to repeat it!

3 (VanDenburgh, 2008)(Harmelink, 2008)

4 http://pdfserver.amlaw.com/ca/newcentury01_0327.pdf

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Section 4 - Bibliography

(2008, October 23 ). Retrieved March 7, 2011, from A plain man’s glossary of finance market terms:

http://www.thepoliticalsword.com/post/2008/10/23/A-plain-mane28099s-glossary-of-finance-market-

terms.aspx

Harmelink, V. &. (2008, December 1). Accounting Implications of the Subprime Meltdown. The CPA

Journal .

Jaffee, D. M. (2008, April 11). The US Suprime Mortgage Crisis: Issues Raised & Lessons Learned.

Retrieved March 8, 2011, from

http://www.growthcommission.org/storage/cgdev/documents/gcwp028web.pdf

VanDenburgh, W. &. (2008, December 1). Accounting Implications of the Subprime Meltdown. Retrieved

March 7, 2011, from http://www.allbusiness.com/trends-events/audits/11729624-1.html

Yale School of Management. (2008, September 18). Retrieved March 7, 2011, from A Root of the

Financial Crisis: http://mba.yale.edu/news_events/CMS/Articles/6603.shtml

Appendix - Subprime Mortgage Crisis

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Section 5 – Appendix: Subprime Mortgage Crisis

The subprime mortgage crisis has major effects on the US economy and impacted individuals,

the housing market, financial institutions, and the government. This appendix presented the causes,

effects, and impact of the subprime mortgage crisis. Figure 2 indicates the lending decisions by

institution and borrowing decisions by individuals as a response to the Housing Bubble Formation.

Figure 2: Subprime Mortgage Crisis – Housing Bubble Formation5

5 Source of Figure 2: http://en.wikipedia.org/wiki/File:Lending_%26_Borrowing_Decisions_-_10_19_08.png

Appendix - Subprime Mortgage Crisis

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Figure 3 depicts the subprime mortgage crisis effects on the housing market, the financial

market, and government and industry responses.

Figure 3: Housing & Financial Market and Government & Industry Responses 6

6 Source of Figure 3: http://en.wikipedia.org/wiki/File:Subprime_Crisis_Diagram_-_X1.png

Appendix - Subprime Mortgage Crisis

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Finally, Figure 4 shows the vicious cycles of foreclosures and bank instability due to the subprime

mortgage crisis.

Figure 4: Subprime Mortgage Crisis – Foreclosure & Bank Instability7

7 Source of Figure 4: http://en.wikipedia.org/wiki/File:Subprime_crisis_-_Foreclosures_%26_Bank_Instability.png