Sub-prime Financial Crisis and the Fair Value Accounting :

On September 21, 2008, the U.S. Treasury and Federal Reserve proposed acquiring $700 billion of distressed subprime mortgages from leading financial institutions in an attempt to restore confidence in financial markets. The government's actions followed a turbulent week on Wall Street in which Lehman Brothers filed for bankruptcy, Merrill Lynch agreed to be acquired by Bank of America, and the Federal Reserve agreed to bail out troubled insurance company AIG. All three companies had been hard hit by the subprime crisis that was devastating the U.S. financial market, and which had caused the Federal Reserve to arrange for Bear Stearns to be acquired by J.P. Morgan and the U.S. Treasury to bail out the mortgage giants Fannie Mae and Freddie Mac.

Under the mark-to-market accounting, many financial institutions had been required to recognize sizable losses on their subprime investments and related securities. These losses were accompanied by dramatic stock-price declines. For the year ended September 15, Citigroup's stock declined by 69%, UBS's by more than 70%, and Merrill Lynch's by more than 75%. In response to the mounting financial losses and battered stock prices, the boards of all three firms decided to replace their CEOs (Citigroup's Charles Prince, Merrill Lynch's Stanley O'Neal, and UBS's Peter Wuffli).

the crisis raised important questions for financial market regulators scrambling to preserve the system, for investors concerned about their portfolios and retirement assets, and for corporations and individuals who found it increasingly difficult to borrow. It also raised fundamental questions about fair-value accounting. Had the method provided early warning signals of the problems at financial institutions, as advocates suggested? Or, as critics argued, had it exacerbated problems by requiring firms to make unreliable estimates of paper losses caused by liquidity problems in the markets? If fair-value accounting was part of the problem, what alternative should take its place? As advocates and critics debated the accounting issues, the Financial Accounting Standards Board (FASB) and Securities Exchange Commission (SEC) were under pressure to consider whether to modify the existing rules.

Do you agree with the argument that fair value accounting contributed to and exacerbated the subprime financial crisis? Explain why or why not.