Impairment of Financial Instruments “Story of Financial Crash at 2008”

Impairment is a financial concept that is used to make sure that the carrying values of current and noncurrent assets or financial instruments reflect their fair values at any given time. This concept is implemented so that the readers of financial statements can get a clear and relevant picture of the financial condition of any entity. 

If we look at IFRS 9, then one of the main changes that it has made over its predecessor standard IAS 39 is in the impairment of financial instruments. However, before we can see how IFRS 9 intends to treat the impairment of financial instruments, we must first try to understand why it was deemed necessary to make this change.

The background to making this change in IFRS 9 from IAS 39 was the financial crash of 2008, which itself is a very broad topic. If we look at the reason for the financial crisis of 2008, then one major reason that appears in front of us is the crash of the housing bubble.
The housing bubble was inflating in USA since at least 4 years before the financial crash, the indicators were there but no one was paying any attention to them. The housing bubble was created by the increased lending by banks.
The banks and other lending institutions got into this frenzy of giving out mortgages and loans without carrying out proper background checks, which itself was a breach of regulations of that time. However, since credit was being given easy and the brokers were raking in millions in commission, the lending to borrowers of all financial backgrounds continued unabated. 

In reality, the mortgages were being given to people with FICO scores below 550, which makes the return on a mortgage extremely risky, in addition to low FICO scores there were no background checks and banks were offering variable interest rates on these already risky mortgages in a market that was seeing reduced interest rates. 

It must be understood that when a bank creates a mortgage, it does not hold that mortgage. The average term for any mortgage is between 10 to 25 years and banks simply cannot wait for this long time to recover their investment. So instead of waiting for 10 to 25 years, banks simply sell the promissory note signed by the borrower promising to pay the mortgage principal and interest. The promissory note is sold to other lending and securitization institutions. 

Once the banks sell their mortgages, their risk is removed. They recover their investment and have no risk left in their books. This is one major reason why prior to the 2008 crash, banks were not carrying out stringent background checks on borrowers. There were even instances of multiple mortgage contracts given out to the same borrower. 

When the banks sold these prime and mostly subprime mortgages on wards to other institutions, funds and securitization agencies, they removed risk from their books. The cycle however did not stop here. The lending institutions which bought these prime and subprime mortgages, turned these mortgages into debt backed securities such as bonds carrying contractual cash flows from the mortgages.

The funds and institutions that purchased the mortgages from the banks knew that these mortgages were prime and subprime, but once these were converted into debt based securities the same banks that sold these mortgages to funds now bought the debt based securities. 

The real question here is why? Banks knew these mortgages were both prime and subprime and by selling these mortgages to other institutions they effectively removed the risk from their books. So why did the banks buy back these debt-based securities which they knew were carrying high risk? The answer is that it was paying good money. 

The more mortgages a bank could lend out, the more money it would get by selling them and the more bonds the banks the more demand there was going to be of mortgages. The "greed" to make more money turned into a vicious cycle for the banks. 
This however did not stop here. This is too simple. 

It is important here to understand that the modern financial system is built upon credit and credit has one major component to it and that is risk. Low risk corresponds to stability but low income, for example if you look at treasury bonds which are investment grade AAA rated bonds, they have the lowest interest rates in the market.
However, junk bonds that maybe rated BBB or below carry higher interest rate for investors. Investors know that junk bonds are risky, but the high interest rate means that if the investors invest in junk bonds, they can make good money, if they are lucky and the bond does not default 😊. 

So, the debt backed securities that the banks were purchasing from funds comprised of mainly AAA and BBB rated bonds. There were however a lot of mortgages, in fact majority of mortgages that were below BBB ratings. So, what was done with them? Well, the funds came up with a new financial instrument called CDO which stands for "Collateralized Debt Obligation"

These CDO`s were financial instruments that comprised of basically high risk mortgages that would have been rated below BBB. However, the funds jumbled up these CDO`s with mortgages of different risk profiles, so in a single CDO there were BB, C, CCC, CC rated mortgages and the loophole which allowed the funds to do this was that the regulations at that time allowed for this.

Mixing risky mortgages of different risk profiles, according to the regulations at that time meant that these mortgages were now diversified enough for the credit rating agencies to label these CDO`s in the "A" category. So a new financial instrument was created that was rated highly but in reality it was full of mortgages and other debt backed securities that were basically junk rated and not being purchased by the market.

This is how the system was running prior to 2008 financial crash. Now the whole chink in the armor of this system was that all these financial instruments, be they bonds, debt backed securities, CDOs or credit default swaps. These were all based simply on mortgages that were going to default and this is exactly what happened.

The housing bubble kept swelling and then a time came when people who could not afford the mortgages because of weak financial backgrounds, now began to default on payments. Once this percentage of defaults reached a certain limit, around 8% it triggered a market wide crash because all of the financial instruments began to crash. Why? Because the financial instruments such as bonds, debt backed securities and CDO`s were standing on the contractual cash flow that was coming from these mortgages. When the cash flow stopped due to default, the financial instruments lost their worth and value and as a result triggered a crash.

How is this connected with IFRS 9?
The problem with what has been discussed above is that all these instruments were bought by corporations and banks and these were shown on their balance sheets. Investors look at the balance sheet and other indicators before investing into any entity and one of the main reasons for preparing audited financial statements is to make sure that the financial statements show a true and fair picture of the company`s financial position.
These instruments were significantly impaired from their inception. For example, take a bond that is more than 65% B rated. The probability of its default is very high, if we assume that the value of the bond is $50,000 and the probability of its default is 70%, then this means that $35000 of investment into that bond are at risk. Thus only $15000 out of $50000 investment was safe and the other was, we can say, credit impaired. 

IAS 39 only impaired financial instruments when they incurred any loss or when their fair value dropped, IFRS 9 takes a more prudent and cautious approach and this approach has been developed with the experience of 2008 financial crash in mind. 

Under the previous standard the bond would have been presented on the financial statements at $50000 till it experienced any loss in value. Under IFRS 9, the bond has to be shown at its credit impaired value because of the introduction of "expected credit losses".

Accounting for the risk inherent in a financial instrument has become necessary and the implications of this is that the financial instruments may or probably will suffer from a loss of value making the balance sheets of many organizations shrink. This however was a necessary step to make sure that the investors can clearly see the level of risk in their target investments and also to make sure that the financial statements show a true and fair picture of the company. 

This was the rationale behind the new model of impairment of financial instruments given out in IFRS 9. We shall now look at this model in greater detail in the next article.

IFRS 9 Part (2)- Measurement