Writing Assignment help on : Questions and Answers

Question No: -1

This statement puts forward a definition for what fair value is and provides a framework for measuring fair value according generally accepted accounting principles. Also this statement makes it imperative to disclose more information about the fair value measurement practices followed by the firms. This statement is applicable under other accounting rules, standards and directives that either requires fair value measurement of the assets or allow the firm to arrive at the fair value of their assets but it does not provide any new methods of arriving at a new fair value. Instead it makes earlier pronouncements more clear and beneficial for the accounting purposes.

Industry had been facing ambiguity and dilemma as what to be expected as fair because there were many different definitions of fair value and at the same time there were very limited guidelines on the same as to how use and apply those definitions in accordance with the GAAP. Also whatever guidance was there, those were dispersed among those many definitions making scene confusing for the accountants as well as assessors and editors because different guidelines resulted into huge inconsistency and sometimes malpractice and this added to the complexity in applying to GAAP. This situation had created huge problems and confusion in minds of the people working industries. So with the aims of eliminating the confusion and ambiguities and provide clear guidelines for the professionals from these definitions of fair value and measurement, the Board came up with statement. This also aimed at increasing the consistency in measurement, comparability and information.

The concept of fair value accounting is based on concept of market value of the assets. It is defined as the price or value the assets would be arrived or gained by selling or transferring in the market to some eligible buyers. This practice of fair value is used for those assets for which arriving at a market price cannot be done because there is no established market for the assets or because of some reasons or barriers, the assets cannot be transacted in monetary terms. According to the FAS 157, the fair value of an assets the amount of the money that the firm can be receive by selling or have to pay to buy between two eligible and willing parties other than liquidation sale of the asset. This practice of fair value measure is done for the assets whose carrying value is based on mark to market valuation method. For example during the assets belonging to collateralized debt obligations class were devalued using the fair value measurement methods because of no market available for those asset classes during the Great Financial Crisis.

While in case of the history cost accounting method, the prices of the assets are based on the historic prices at which those assets were bought and it has nothing to do with the current prices of the assets. In case of historic cost accounting methods for example if a piece of land was bought by a firm ten years ago at a price of $1 million, the price will carried on even after ten down the time irrespective of whatever the value of the land may be, higher or lower.

So the treatment to assets in these two methods of accounting it quite different in which one is based on current prices irrespective of at what price the assets were bought while other is based on the historic cost; the prices at which the assets were bought ignoring the current market prices of the assets.

There are many merits and demerits in the fair value measurement methods. With the help of the fair value measurement methods, one can arrive at the value of those assets too that does not have any active market for transactions. This provides information about the clear picture of the financial assets in question. So if arrived at carefully, it provides clear picture of the financial health of the firm. But at the same time it has huge demerit that if not used wisely and carefully, this result into huge problems for the firm like Great Financial Crisis of 2008 because it is prone to be misused for many unsolicited reasons like writing off bad assets and improving the financial health; mainly in case of banks and financial institutions.

There is no clear answer as to whether it is appropriate to use the fair value measurement methods or not when the market is under stress. In many cases, using this can be very useful and beneficial for the firms and industry and in many cases, this may result into disaster. It all depends on how and why this practice is being done and to what extent.

In case of many banking and financial institutions during the financial crisis of 2008, many of the banks and financial institutions hugely depended on the writing off the non performing assets using the fair value measurement mechanism just with aims of only improving the balance sheet of firm for short term purposes and avoid any negative sentiments because key ration tending negatively. For this purpose, the financial institutions and banks tried to write off as much possible at lowest possible prices ignoring many facts and figures. But these practices resulted into huge deterioration in value and volume of the assets hold by these organizations but hardly having any positive impact on the liabilities sides of the balance sheet. Just like window dressing, huge real differences between the assets and liabilities arose that led to collapse of many banks just because of excessive use of fair value measurement methods. So it can be said that using fair value measurement method is not very much appropriate and beneficial.

While in the market conditions and economy, some banks and financial institutions used this very wisely and in limited way with the purpose of avoiding any negative swings. So these firms priced assets more realistically and finally survived the Great Financial Crisis of 2008. Unlike other firms, these used fair value measurement method to strengthen their financial positions without unbalancing the whole balance sheet. So from this experience it can be said that using fair value measurement method is appropriate as it provide right and exact information exact financial position of the firms.

As I said earlier, that the appropriateness of the usage of the fair value measurement method is dependent on the firms intentions, strategies and the way it is being done as well as pragmatism in the goals of whole practice.

Question No: – 2

In modern structure of the financial markets, the values of the financial assets are the most important factors that directly have impact on almost everything relating to the assets. According to the mark to market pricing method the assets are valued at the market prices. But there are huge difficulties in arriving at the prices for the assets because the model itself looks to be flawed because it is almost not possible to establish the real prices of the financial assets or instruments. Different people sticking to different yardstick end up having different prices for the same assets. This leads to volatility in the market. Banks have a valuation system that is based on the mark to market accounting methods and practice that values its assets or financial instruments on the basis of the expected market value of the assets and these assets hardly have an active market. So in practice the whole valuation is based on some assumptions and rationales (different for different banks depending on their experiences with the particular class of assets).

In banks each and every class asset has its own system for arriving at the fair value of the asset using mark to market method in doing so and for all this practice the banks stick different standards and benchmarks according to its own convenience. So as a practice when the banks value and price their assets, they analyse the prevailing market conditions as well as expected market conditions on the basis of the assumptions made by them based on its previous experiences and expertise because the values of financial instrument are dependent on the prevailing and future market conditions. These assumptions are largely based on the internal reports and researches as well as industry reports by research agencies as well as credit rating agencies. But finally it is the goals and the intentions that are expressed in the prices of the assets in question (Weil, 2007). So when the banks are engaged in pricing drive, it becomes important to ensure that whatever prices they arrive at looks to be expression of the market and is believed legitimate and real. To meet this purpose, they support the prices with all the required and relevant rationales and information as well as facts and figures that can justly the projected cash flows from those financial instruments (Kolev, 2008).

To this end purpose they present the facts and figures supported well researched reports and the books of accounts in such a fashion it looks to be the real market prices and legitimate and the environment that is often created by the banks also helps these prices to sustain in the market leaving no doubt in minds of the investors who would be subscribing or investing in the assets. All these exercises are backed with proper paper work and other supporting documents leaving any stone unturned. These are the reasons why these are often referred as the mark to make believe prices because these prices are often made to believe rather than the search of real prices (Hunt, 2009).

In normal cases the banks follow a computer based pricing model with some specific changes that carry different weights for different various and sometime different variables too. This model is computer programmed model and factors like economic conditions of the market such as GDP growth, liquidity in the market, interest rates, inflation, market conditions in that particular asset market; other adjustments etc are assigned with different weights. So in this case current market prices of asset does alone decides the prices of assets but in of mark to market method, the current market prices prevails and find far higher weight than the conventional model followed by banks.

Question No: – 3

With the start of new century, the real estate market in the US started booming. During the times of the property booms, the interests started falling and fell historically very below. Both the property market boom and historically low rates of interest increased demand for real estate properties as the real return from the real estate was very high. These high real returns resulted into a new behavioural change in American investors. They started investing in booming real estate by borrowing money from financial institutions and banks at lower rate of interest with the purpose of earning higher returns on the investments. This increased huge demand for the real estate properties in the US.

The demands for the real estate properties surpassed the supply and builders found it difficult to meet the demand. This excessive demand resulted into huge investment in real estate properties by corporate bodies. As result of high demands and lower supplies, the prices started increasing and this acceleration rate was very high. And a number of people across the sections as well as the nation started earning handsome returns from the investments in real estate assets.

It was the same time period when the US economy along with the world economy was growing steadily. The favourable economic as well as market conditions and very high liquidity in the market where credit was available at very cheap rates, banks and financial institutions also found that this behavioural change was present huge opportunities to earn some easy money. The high returns from the real estate properties, increasing demands of real estate, favourable economic and market conditions and falling credit expansion because high liquidity in the economy encouraged the banks and financial institutions to reposition their lending strategies to expand customer base. The financial institutions at the point of time found that there was easy money in the real estate sector. So with the aims of increasing top and bottom line they started lending to everyone irrespective their credit worthiness.

There are two lending strategies; prime lending and subprime lending. In normal cases, banks prefer to prime lending practices as it being the safest lending strategy because of the very high ability of borrowers to pay back and backed with huge resources and income that would help them to pay back. Prime lending rates are always lower than any other rates. The second practice it of subprime lending and it is considered to be risky and aggressive strategy of the banks to expand the credit net. In case of subprime lending, the banks and financial institutions lend to less worthy and more risky borrowers at a higher rate than the prime lending rates because the ability the subprime borrowers to service and pay back the loan is lower and often not backed with enough and proper securities and incomes. So lending at sub standard terms or subprime rate is profitable for the banks and financial institutions once they close such accounts but at the same time increases risks ransacking the composition between the prime and subprime loans.

The property boom, increasing demands, high returns, low rates of interest and expansionary credit policy, greed of banks and financial institutions and no regulatory intervention, people developed a new set of behaviour of borrowing money with the aims of investments in real estate and other sectors too. At the same time property traders and builders started offering easy access to credit money in association with the financial houses and banks. This resulted into artificial demand for real estate properties not for consumption.

The overall trend in market over a short span of time resulted into huge capacity creation in real estate market as corporate bodies invested billions of dollars in real estate mostly borrowed money (prime and subprime both) to make easy money that resulted into oversupply of the real estate in the market. The demands for the real estate properties was already an artificial phenomenon, this coupled with oversupply, the prices of properties started falling sharply on one bright morning and in short span of time the situation worsen and value of the real estate investments became junk for the investors. This resulted into huge panic in investors, lenders as well as builders. They all acted in heft that eventually made the things even uglier for everyone as all the three classes had already invested billions of dollars in real estate.

Initially it was expected that it was market correction but in few days all the stakeholders realized that it was bubble led growth in the market. In few weeks the prices were on negative side and everyone in market found to be option less. So they decided to control the damage to their worth in their own ways. Everyone, the investors, builders and financial institutions ceased their activities.

Everyone was hit. In mean time investors found merit in not paying their debts and instead to surrender their properties to financial institutions and banks to safeguard themselves from losses. In few weeks, maximum of the borrowers did the same and banks and financial houses became owner of worthless properties in the US with no or negligible cash flows decided to part away with the assets and not to pay loans and surrender assets to banks and financial institutions.

During the same period investment bankers with help of mortgage lenders started selling complex debt based financial instruments in the market with the same hopes and goals of easy money by packaging attractively with promises of high returns. All types of investors bought these complex financial instruments such collateralized debt obligations and mortgage backed assets to cash the opportunities offered by real estate sector. And once the thing become ugly, scenario became uglier and the Great Financial Crisis was in offing. Because of the crisis having its origin in the lending at subprime rate, this crisis is called subprime crisis.

As a result of the crisis the banks suffered heavy losses and were piled up with nonperforming assets. More than hundreds of banks collapsed including Lehman Brothers, CEOs of top company were sacked and government was forced to come up with bailout package for banks and other financial institutions. Some of the biggest name in financial and banking industry such as Citi Bank, Merrill Lynch, Goldman Sachs and AIG etc were at verge to collapse while Merrill Lynch collapsed. So most of the banks in the US were hit hard and made huge losses (IMF, 2009).

According to me Australian economy can also be hit by such subprime lending problems as there are reports of subprime lending but this is very much limited. So, it is does have so kind of danger that it posed and ruined the American banking and financial industry. So I can say it is not a problem but it is needed to discourage such practices.

Question No: – 4

Collateralized debt obligations are structured financial instruments that are structure and packaged on the assets created by banks by lending to real estate industry and borrowers. These are assets baked securities having many tranches that offer different levels of risks for different tranches. These assets are issued specialized financial institutions often investment bankers that have expertise in complex financial products. These financial instruments offer 2-3% higher returns than the corporate bonds of same categories. The value of collateralized debt obligations and the payments to investors is derived from the incomes from the portfolio of fixed income assets of different risks.

Each trench of these assets offers different returns depending on risks to different demands of the different investors. These financial assets are categorized in different categories depending on the risks and returns as senior and junior. The senior collateralized debt obligations offer lowest risks and the lowest returns and are considered to be safest securities of the lot. Junior CDOs offer highest risk and returns either in form of higher coupon rates or lower prices.

The banks who lend huge money with the purpose of decreasing their risks package these loans and sell these to investment banks and other financial institutions at some coupon of discount. This improves their balance sheet and decreases the risk of defaults. And all the risks that the banks bear are shifted to the investors who invest in these collateralized debt obligations. So to some extent it is risk mitigation strategy for the banks that offer opportunities to investors to earn higher returns from the investments. So it is said to be win-win formula for both; banks and investors. During the real estate boom, this particular instrument was key to increased lending to real estate sector.

The values of the collateralized debt obligations are totally dependent on the values and the cash flow from the bonds and loans that constitute the portfolio. Any change in the values of the bonds or loans or the both have direct impact on the value of the collateralized debt obligations. If the value and cash flow from the portfolio of the bonds loans increases the value of CDOs also increase vice versa (Deb, 2008).  But the crisis started, the value of CDOs became junk and banks were forced to devaluate their holdings in such products using fair value and mark to market valuation methods.

To some extent CDOs were responsible for the crisis as these provided huge ways to mitigate risks to others in the hands banks and they hardly cared for the quality of lending practices. But it would not be fair to solely blame fair value measurement system for the banking in the US but to some extent, it can be said that this practice of fair value measurement system offset the crisis and increased the gravity of the problem. But this was mostly because of the lending practices followed by banks (Nanto, 2009).

Question No: – 5

I feel it is his personal views if Mr. Schwartzman finds that the market is somehow wrong or wildly inefficient. And I think the reason behind his own conditioning that he has got in the private equity business. None in the market had been able to tam the trend and this is not a bad sign. Instead it indicates towards efficiency of the market. Market said to be efficient when none can predict it. So market cannot be called inefficient. Neither the CDOs nor the capital market was price efficiently before the Great Financial Crisis. All the assets were priced on the basis of some artificial conditions in the market, so were the CDOs. So we can say that the capital market was not efficiently before and during the crisis period but it is going to normal conditions were prices are realistic.

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