They consist of loans made to subprime borrowers. Subprime borrowers are those borrowers with a low credit score or high debt to income ratio, and lenders consider them as risky clients because of the capacity to repay the loan. Usually, loans to subprime borrowers are subject to higher interest rates. Some U.S. financial institutions use credit risk scores provided by the U.S. credit bureaus (Equifax, Experian, or TransUnion) in addition to the FICO credit score because depending on the provider of the credit risk score, the credit risk score may be different although it may have been calculated for the same quarter. FICO is a software company that predicts consumer behavior using big data and proprietary statistical models in order to provide credit scores in order to quantify the risk associated with clients. It is based on San Jose, California, but it has operations in different countries. A low credit score is usually as a result of late payments, missed payments, or excessive debt. For instance, the range of the FICO score goes from 300 to 850, and scores under 600 may be considered subprime. The debt to income ratio is also a common ratio used by financial institutions to identify subprime borrowers. The debt to income ratio shows the amount of total debt that a client has in relation to the gross amount of income generated. Therefore, the lower the value of the ratio the better. For instance, if a client has a monthly gross income of $5,000, monthly mortgage payment of $2,000, a monthly car payment of $400, and a monthly alimony expense of $600, then debt to income ratio will be calculated as follows: Debt to income ratio= (2000 + 400 + 600) / 5000 = 0.6 = 60% In a case like this, the debt to income ratio is high because 60% of the gross income goes towards covering current debt, so the possibility of this client being approved for a loan is low. Therefore, the client has to lower the amount of his monthly expenses or increase the amount of his income in order to reduce the value of the ratio.
Published in Chapter:
Accounting Standards in the U.S. Banking Industry during the Financial Crisis
Copyright: © 2016
|Pages: 14
DOI: 10.4018/978-1-4666-9484-2.ch007
Abstract
The global financial crisis became evident when U.S. house prices fell related to the subprime mortgage-backed securities crisis. In the years preceding the financial crisis of 2008, there was a real estate bubble that pushed U.S. real estate prices to high levels, and at the same time financial institutions were holding large amounts of subprime mortgage-backed securities. Fair value accounting (FVA) and its link to the recent global financial crisis has been a focus of discussion and interest for accounting researchers, financial analyst and policy makers. During the financial crisis, a large percentage of assets in the balance sheets of banks were calculated using fair value. The main concern was that those assets were calculated using mark-to-model accounting (Goh, Ng, & Yong 2009). There are still contradictory conclusions on the implications of fair value accounting and the global financial crisis (Laux & Leuz, 2009). The main objective of this chapter is to provide a better understanding of the global financial crisis and of the mechanisms of fair value accounting.