One of the most difficult aspects of the current economic malaise to explain has to do with complicated accounting rules dealing with a concept known as fair value. The Financial Accounting Standards Board, or FASB, issued two standards which radically changed the way certain financial transactions were recorded. Traditionally–with few exceptions–assets and liabilities were recorded at their historical cost. FASB Statements 157 and 159 allowed companies to record assets at their fair, or market, value. As early adoption of these standards took place, companies could determine their value based on what the market would pay for them. The problem with this idea is that the market for these securities was created by at least one party to any of these transactions, thereby impairing the independence of the transaction. For a while this method worked just fine, until the markets for securitized mortages and other complicated collateralized debt obligations (CDOs) siezed up. As soon as the market for the assets dispappeared, the accounting rules for them changed dramatically. Assets that were once considered Level 1, or based on “quoted prices in active markets,” were now downgraded to Level 3, where only “unobservable inputs for the asset or liability” exist (FASB Statement No. 157). Companies were forced to rely upon complicated, and often proprietary valuation methods, based largely on “black box” computer models no human could ever hope to understand or explain. Large writedowns result when the asset’s valuation method changes and the certainty of that valuation comes into question. While the market may have allowed for and even encouraged inflated asset prices (yes, we’re talking bubble), accounting rules do not. This is another cause of the substantial writedowns most banks have announced over the last year.
To recap: Bear Stearns announces is has pumped cash into two failing hedge funds. As a result, the market for mortage-backed securities and other CDOs evaporates. Thus, accounting rules for those securities change and massive writedowns ensue. Hence, accounting standards caused the credit crisis.