The current economic condition of the United States is estimated to begin turning around in the near future, with the use of stimulus packages as well as numerous legislative reformations. However, the cause of the 2007 recession is still currently debated with fingers being pointed at the housing bubble, banks, lack of regulation, and a lack of transparency to name only a few. While the exact catalyst for the 2007 recession is still being discussed, the effect the recession has had on the general population, government, banks, and the auditing and accounting professions is becoming crystal clear.
Causes of the Current Financial Recession
The most obvious culprit pertaining to the creation of the current recession is the mortgage and foreclosure crisis. When attempting to understand what caused the mortgage crisis one must trace the origins of the mortgage loan. Banking institutions, such as Freddie Mac and Fannie Mae, have been held responsible for their poor financial decisions. Through the guarantee of high-risk mortgages, the high demand for housing, housing prices, and the lax federal money policies, the cause of the current financial recession is clearly multi-faceted.
High-Risk Loans Guaranteed
In an attempt to encourage home ownership among a lower socioeconomic bracket, large lending banks began to guarantee high-risk loans at an alarming rate; some as low as 1%. This also led to a huge increase in subprime lending. The delinquency rate remained somewhat low at first, but as we got closer to 2007 the percentage began to increase drastically. The banks also felt the pressure from an increase in home ownership demand due to the lowered interest rate and felt that they needed to competitively decrease their rates to stay in the game. This allowed the general population, across all income brackets, to seek mortgages that may have previously been outside of their financial reach. Now, since the banks knew that these loans were high-risk, they secured them by turning them into securities or CDO's. Banks began to "pool their loans into sellable assets, thus offloading risky-loans onto others." [1] By doing this, the banks were off the hook and the buyer of the security would receive regular payments from all the different mortgages. It was a win-win, or so it seemed. The banks would pay people to rate these security packages which was a conflict of interest. Many were given a really good rating or close to it which made it attractive to buyers, even though they all generally had the same risk and it was usually high. [2]
Housing Market Becomes Saturated by High Demand
People, who were never capable of affording a mortgage loan before due to their low income or credit score, were now able to receive these subprime mortgages without any trouble. This caused the housing market to boom and the demand to skyrocket. People were buying houses left and right that they honestly couldn't afford, but because of the low rates on their mortgage, they did it anyway simply because they could. Often times, they were receiving these loans on an adjustable rate mortgage (ARM) which meant that they interest incurred was more than they were paying or originally told, but were unaware of the change in their interest rate.
Housing Prices Soar
Because of the new high demand for houses housing prices began to soar between 1997 and 2006, right before the bubble burst. Because of this significant rise in housing costs, the only thing that could be expected to happen would be for interest rates to increase as well. No one could have expected for these low rates to last forever. When the interest rates began to rise again, people were no longer able to pay on their mortgages, nor were they capable of refinancing their loans so many people began to default and/or foreclose.
2007 Housing Bubble Bursts
Between 2005 and 2006, housing prices started to decline while interest rates went up and then in 2007 the housing bubble finally burst. Interest rates were still high and people were paying on mortgage loans for houses that were no longer worth anywhere near what they had originally purchased them for which caused many people to be unmotivated to pay on their loans so they instead defaulted and many foreclosed. This was not good for the banks and investors because not only did they not have their money, the collateral was no longer worth anything either.
Fed's Easy Money Policies
Many people point the finger at Federal Reserve Chairman Alan Greenspan for the economic effects of the housing market rise and fall. He was the one who originally had the plan for the "Easy Money Policy" and first put it into affect by takes rates as low as 1% and below 2% for almost 3 years. This is what originally caused the housing market boom because it brought the mortgage interest rates to all time lows. He failed to mention the negative impacts of this and how, due to the low cost borrowing, financial institutions were taking on very high risks which led investors to put all these borrowed funds into all kinds of investments including the many mortgage-lending vehicles. [3] In 2005 when the rising interest rates and the rise in housing prices cause borrowers to be unable to afford the housing that they wanted, the borrowers and lenders did not want to give up. These borrowers and lenders again lowered their standards and rates so that people would keep borrowing at high-risk and Greenspan's Fed let it happen. Greenspan actually made it worse by suggesting borrowers to take out ARM's by saying it would save them money in the long run. And not only did he give bad financial advice, he allowed banks and lenders to take advantage of his easy money policy and write increasingly risky loans and also not state their most risky assets on their balance sheet. [4]
Contribution of Auditing Profession to Recession
What Could the Auditors Have Done Differently?
There has been a lot of debate on whether auditors should be partly to blame for the recession. Many people believe that if they had done some things differently, that things could have been prevented and that maybe the outcome would not have been as detrimental to the economy. Jake Bernstein wrote an article saying that the accounting firms who audited the banks failed to make sure that the banks had enough money in their reserves to cover potential loan defaults. [5] KPMG was actually sued by New Century, one of the biggest banking failures, for 1 billion dollars stating that it was because of their "grossly negligent audits" and cover up of accounting and financial errors that caused their collapse. [6] Federal inspectors found 36 other similar auditing mistakes made by six of the biggest accounting firms and numerous other errors. [7] Many also think that they failed to provide substantial risk assessment and that it should have been obvious that these banks were operating at a very high risk. It is believed that if banks had been advised or forced by their auditors to create bigger reserves after they had thoroughly and accurately evaluated the risk of these outstanding loans, then they might have been more conservative in their lending habits and maybe a bit more skeptical and the horrendous outcome could have been somewhat avoided if not entirely for some.
In the Auditors Defense
Many of the mortgage loans that these auditors would have been expected to evaluate were grouped together into single CDO's or collateralized debt obligations. These CDO's were then evaluated and rated by a rating agency from low to AAA, or high. These ratings were not always correct and often misleading which was unknown to the buyer. When an auditor assessed the risk of these loans, the first thing they looked at was these ratings given by an independent, external rating agency which is considered to be one of the most trusted sources of information in the auditing world and isn't often questioned. Because of this, they did not feel the need to go into much further investigation of the risks of these CDO's because the source of the information was assumed to be reliable.
How Will the Recession Effect the Auditing Profession?
Changes in External Auditing Standards
In 2007 when the financial crisis was first beginning many auditing standards were already in the process of being changed after the fall of Enron and WorldCom and the implementation of the Sarbanes Oxley Act in 2002. These changes placed an emphasis on internal controls and risk management, areas that many people blamed for playing a part in the cause of the current financial crisis. These new standard required auditors to gain more understanding of the client's internal controls and obtain more detailed information regarding the client's business objectives and the risks involved. [8] The implementation of these new standards will help to prevent some of the mistakes that many auditors were accused of making during the years that caused the recession.
Increased Use of Internal Auditors
Where most of the changes will take place is in the Internal Auditing sector. In the results of an IIA survey done in May of 2009, 53% agreed (and 23% disagreed) that "internal auditing could have helped identify key risks to mitigate some of the current economic impacts their organization is facing." Many respondents say that they have increased focus on operational risk and the assessment of the effectiveness or risk management. [9] People have realized the benefit of having strong internal auditors and the preventative measures that they are capable of taking. Because of this, there is a good chance that a lot of money and efforts will be put into developing strong internal auditors to help catch these problems before the external auditors and just in case they might not see it.
Pointing the finger to the culprit of the cause of the worst financial crisis since the Great Depression is a hard choice to make because it is not possible to blame just one person or party. Many people were at fault and the only thing that can be done from here is to learn from the mistakes that were made and grow from them. For the Auditors, they simply need to do their job and do it well according to the guidelines and standards that have been set out for them. Being lazy and un-thorough will not be acceptable especially when determining risk levels. Many changes will be made by more than just auditors and we can only hope that it will prevent a financial crisis like this one from ever happening again.
