Citigroup and Subprime Lending.

Date: November 6, 2009

To: Management

From: Mustapha Tarawally

Subject: Citigroup and Subprime Lending.

On September 6, 2000, Citigroup, Inc. announced an agreement to acquire Associates First Capital Corporation in an exchange of shares valued at thirty one point one billion. By then, the major profit source for CitiFinancial and the Associates was subprime lending (Baron, 2006, p.801). Subprime lending is the practice of extending credit to borrowers with certain credit characteristics  example a Fair Isaac Company (FICO) score of less than six hundred and twenty that disqualify them from loans at the prime rate (hence the term 'subprime'). Subprime lending covers different types of credit, including mortgages, auto loans, and credit cards. Since subprime borrowers often have poor or limited credit histories, they are typically perceived as riskier than prime borrowers. To compensate for this increased risk, lenders charge subprime borrowers a premium. For mortgages and other fixed-term loans, this is usually a higher interest rate; for credit cards, higher over-the-limit or late fees are also common. Despite the higher costs associated with subprime lending, it does give access to credit to people who might otherwise be denied. For this reason, subprime lending is a common first step toward “credit repair”; by maintaining a good payment record on their subprime loans, borrowers can establish their creditworthiness and eventually refinance their loans at lower, prime rates.

To add more, subprime lending practices can be analyze under utilitarian, right, and justice principle of ethics to ascertain the major problems associated with it.

Utilitarianism

This is an ethical principle that seeks to do the greatest good for the largest number of people lending (Baron, 2006, p.693). Under this ethical standard certain individual rights are expected to be sacrificed for the protection of the masses. The Equal Credit Opportunity Act (ECOA) prohibits discrimination in any aspect of a credit transaction. It applies to any extension of credit, including extensions of credit to small businesses, corporations, partnerships, and trusts. The ECOA prohibits discrimination based on:  race or color, religion, national origin and sex (Fair Lending Examination Procedures, 2006). The decision by Citigroup to invest in the subprime lending was for the interest of the majority. Almost more than sixty percent of the entire population of the United States falls under the middle class family with low credit ratings and limited disposable income, (Horne, 2009, p.410). So, the subprime lending initiative serves as means for these families to realize their American dreams by acquiring their own houses.

Rights

This principle of ethics relies upon the foundation that everybody in a society is entitled to certain guaranteed rights.  Individual rights are often at conflict between the world of legality and the world of morality. For instance, it should be assumed that everyone has the right to have their health taken care of by a government that taxes them to pay for unnecessary military weapons that don't even work when the order is put through, but if someone can't pay for medicine buys them illegally from another country they can be jailed (Berkley and Watson, 2009, p.3). Under this principle, there is an ethical obligation or duty as well as a right to do the thing in question. Also, every individual who is not a minor have capacity to contract and to meet the obligations of such contract. Citigroup have the moral and legal right to treat their customers fairly under the Truth in Lending Act. Also, Citigroup fails to explain the necessary disclosures associated with the subprime mortgages which result in hardship for some homeowners. These acts are referred to as mortgage fraud. Mortgage Fraud is defined as the intentional misstatement, misrepresentation, or omission by an applicant or other interested parties, relied on by a lender or underwriter to provide funding for, to purchase, or to insure a mortgage loan.

Justice

As the adage goes “those who come to equity must come with clean hands” Justice, then, is a central part of ethics and should be given due consideration in our moral lives. In evaluating any moral decision, we must ask whether our actions treat all per equally. If not, we must determine whether the difference in treatment justified: are the criteria we are using relevant to the situation at hand?  The growth in subprime lending was also driven by aggressive marketing by the subprime lenders (Baron, 2006, p.801). These aggressive acts violate the justice principle of business ethics. For instance, in a landmark case concluded in September 2002, the Commission charged that two of Citigroup Inc. subsidiaries, Associates First Capital Corporation and Associates Corporation of North America, engaged in systematic and widespread deception and other illegal lending practices. The Commission complaint alleged that the defendants at one time the largest subprime lenders in the United States lured consumers into high-cost loans through false and misleading statements and half-truths about loan costs, packed single-premium credit insurance into loans, and violated numerous federal laws, including the Truth in Lending Act, the Fair Credit Reporting Act, and the Fair Debt Collection Practices Act. The defendants paid two hundred and fifteen million for consumer redress to resolve the charges, in addition to a concurrent twenty five million class action settlement (Department of Justice, 2007, p.4).

Recommendations.

Citigroup are in business for the same reason as any other businesses – To make money.  Citigroup make money from fees, deposits held in your account and interest.  This amount must cover wages, technology and administrative expenses, bad loans and leave a little for the shareholders.  To ensure the Citigroup makes money requires viable investment and transparent business practices. On the other hand, business generally preach that the central focus of any business are the customers but, they are not treated them that way. They never live up to the mottos of corporate culture insisting that the customer is always right.   

The subprime mortgage investment will be a good investment plan if, it is carryout effectively and efficiently. One way to achieve positive return on investment from subprime lending is by inculcating corporate social responsibilities. Research studies have proved that businesses that uphold the concept of corporate social responsibility are those that survive during the economic downturns. Through Corporate Social Responsibility activities firms contribute to societal well-being by meeting consumer demand, providing jobs, developing new products, and paying taxes that fund public programs (Barons, 2006, p.653). This will help businesses align both market and non market issues for successful future dealings.

As for sales representatives, Citigroup should provide moral, professional, and official responsibilities training in order to acquaint their sales representatives on issues in meeting consumers as well as company’s goals. For someone to have a moral responsibility for some matter, means that the person must exercise judgment and care to achieve or maintain a desirable state of affairs. Professional responsibility arises from the special knowledge a person possesses. Mastery of a special body of advanced knowledge, particularly knowledge which bears directly on the well-being of others, distinguishes profession from other occupation. Official responsibility that is, a responsibility that someone is charged to carry out as part of his/her assigned duties (Beauchamp and Veatch, 1996, p.45). To crown it all, financial motivation will be base on how efficient and effectively these training procedures are adhering to in their daily routine by the sales representatives.

FOREIGN TAX CREDIT ON CORPORATION

The Unites States (U.S.) retains the right to tax its citizens and residents on their worldwide taxable income. This approach can result in double taxation, presenting a potential problem to U.S. corporations with foreign income and individuals who invest abroad. Double taxation occurs when foreign income is taxed by both the United States, as well as by the country where the income was generated. To reduce the possibility of double taxation, Congress enacted the foreign tax credit (FTC) (Willis, 2011). The corporate foreign tax credit is a set of provisions designed by Congress to eliminate potential double taxation on the foreign source income of U.S. corporations. The current provisions allow U.S. businesses to credit their foreign taxes paid, accrued, or deemed paid against their U.S. income tax liability, subject to limitations that prevent taxpayers from using taxes paid in a country with a higher tax rate than the U.S. to offset their tax liability on U.S. income. The credit is a dollar-for-dollar reduction of U.S. income tax liability (taxpolicycenter.org, 2010). 
Corporations are required to calculate this credit separately for different income categories to prevent taxpayers from combining income that is traditionally taxed at low rates, such as dividend or interest income, with income that is typically taxed at higher rates, such as active business income. Internal Revenue Code Section 901 specifies the provisions for the foreign tax credit. Corporations report the foreign income and taxes related to the credit on Form 1118, Computation of Foreign Tax Credit-Corporations and attach it to their corporate tax return (irs.gov, 2011). The foreign tax credit is elective for any particular year. If the taxpayer does not choose to take the foreign tax credit Section 164 allows a deduction for foreign taxes paid or incurred. A taxpayer cannot take a credit and a deduction for the same foreign income taxes. Foreign tax credit is a type of nonrefundable credit that is subject to carryover provisions if they exceed the amount allowable as a credit in a given year. Unused credits may be carried back 1 year and forward 10 years.  The taxes can be credited in years when the formula limitation for that year exceeds the foreign taxes attribution to the same tax year. The carry back and carry forward provisions are available only within a specific basket. Excess foreign taxes in one basket cannot be carried over unless there is an excess limitation in the same basket for the carryover year (irs.gov, 2011).

The foreign tax credit is available to individuals with foreign source income, including wages earned abroad, but the great bulk of foreign tax credits go to U.S. corporations with operations abroad. U.S. corporations earn foreign source income by operating branches abroad and by operating or investing in affiliates incorporated abroad. If the foreign source income is earned through a foreign branch, it is subject to U.S. tax in the same tax year in which it is earned. The tentative U.S. tax is simply the U.S. tax rate times the income of the branch. A credit is given for foreign income taxes and for any foreign withholding taxes that are levied when the branch remits the income to the U.S. parent. Losses incurred by a foreign branch can be deducted from the corporation’s domestic source income to reduce the corporation’s U.S. income tax. In succeeding years, however, if the branch becomes profitable, its income is treated as U.S. source income and no foreign tax credit can be claimed on it until the U.S. Treasury recovers the reduction in tax revenue caused by the branch’s initial losses (Rousslang, 2005). If the foreign source income is earned through a foreign affiliate that is a separate company incorporated abroad, the income generally is subject to U.S. tax only when it is remitted as dividends to the U.S. parent corporation. The U.S. tax on unremitted earnings is thus deferred until the earnings are repatriated. This is advantageous to the corporation because of the benefits associated with deferral of tax (Rousslang, 2005).
To be eligible for a credit for foreign taxes on the affiliate’s income, the U.S. parent must own at least 10 percent of the affiliate. A foreign affiliate that is separately incorporated abroad and that is at least 10 percent owned by the U.S. parent is called a foreign subsidiary. A subsidiary distributes dividends to the U.S. parent from earnings and profits after foreign income taxes. To determine the tentative U.S. tax and the foreign tax credit for the dividends, it is necessary to construct the underlying foreign source income from which the dividends were derived. The formula for the tentative U.S. tax (TA) on the underlying foreign source income is TA = tUS D/ (1 − tF), where D is dividends, tUS is the U.S. tax, and tF is the foreign income tax rate used for purposes of calculating the foreign tax credit (foreign income taxes paid divided by the subsidiary’s earnings and profits as measured using the U.S. definition of taxable income). From the tentative U.S. tax, the U.S. Corporation subtracts the sum of the foreign income taxes paid on the income underlying the dividends plus the foreign withholding taxes on the dividends. If the difference is positive, the U.S. Corporation owes a residual U.S. tax. If the difference is negative, the U.S. Corporation is said to have excess foreign tax credits (Rousslang, 2005).
In general, the U.S. parent corporation is allowed to sum the foreign source income and foreign taxes from all of its foreign operations, both branches and subsidiaries, when calculating the foreign tax credit and the residual U.S. tax. To be lumped together, however, the foreign source income must be within the same category of income (or income “basket”), as defined by the Internal Revenue Code. The main income baskets are for passive income (primarily interest, dividends, royalties, rents, or annuities received by the subsidiary), financial services income (income earned in banking, insurance, or finance), shipping income (income earned in international shipping), and general limitation income (primarily income earned abroad in the active conduct of a trade or business other than financial services, shipping, or income in the passive basket). Income in each of these baskets is subject to a separate foreign tax credit limitation. The maximum foreign tax credit that can be claimed in any basket (the foreign tax credit limitation) is the tentative U.S. tax. Any excess credits can be applied to offset the residual U.S. tax on foreign source income earned during the previous two years or the following five years, but if the credits cannot be used within that period, they are lost (Rousslang, 2005).
The separate income baskets help discourage U.S. corporations from moving offshore some types of highly mobile investments (such as international shipping, financial services, and portfolio loans) that can easily be located in low-tax countries. Subpart F of the Internal Revenue Code denies deferral for income from such investments, but U.S. corporations might still have a tax incentive to locate these activities abroad if they were allowed to combine the income and foreign taxes from these investments with those from other, less mobile, business activities that often generate excess foreign tax credits. The separate income baskets remove this incentive (Rousslang, 2005).
The FTC is progressing yearly. In 2005 (the latest year for which tax data are available), US taxpayers claimed over $90 billion of foreign tax credits. The foreign tax credit offsets most of the U.S. tentative tax on foreign source income. Compare to 2004, total taxable foreign source income of U.S. corporations was about $150 billion. Foreign taxes on this income (income taxes and withholding taxes) amounted to about $87 billion, of which about $50 billion was creditable against the tentative U.S. tax. The residual U.S. tax on the income was about $15 billion (irs.gov, 2011).
To prevent taxpayers from crediting foreign taxes against U.S. taxes levied on U.S. sources taxable income, the foreign tax credit is subject to a limitation. The foreign tax credit for any taxable year cannot exceed the lesser of two amounts. First the actual foreign taxes paid or accrued. Second the U.S. taxes (before the FTC) on foreign source taxable income. The foreign limitation is derived in the following manner FTC limitation is equal to Foreign-source taxable income/Worldwide taxable income multiply by U.S. tax before FTC (irs.gov, 2011).

Summer 2011-downgrade of the U.S sovereign debt rating.

On August 6, 2011, a credit rating agency Standard & Poor's (S&P) downgraded the credit rating of the United States (US), stripping the world's largest economy of its prized AAA status to AA+ rating. The reason behind this, the debt ceiling debate devolved into partisan bickering. S&P also cited dysfunctional policymaking in Washington as a factor in the downgrade. The political climate in congress is now view by Americans as becoming less stable, less effective, and less predictable than what was previously believed. Congress and the Administration recently agreed to falls short of what, in our view, would be necessary to stabilize the government's medium-term debt dynamics which send negative implications to credit rating agencies. Also, failure to reach agreement in 2013 on a credible deficit reduction plan and a worsening of the economic and fiscal outlook would likely result in a downgrade of the U.S. sovereign rating," the agency said in a written statement (Sahadi, 2011). 


The downgrade puts the U.S. debt rating on par with that of Belgium, but below countries like the United Kingdom and Australia. The country's new S&P rating is AA+ still strong, but not the highest. Rating agencies analyze risk and give debt a "grade" that reflects the borrower's ability to pay the underlying loans (Riley, 2011). The implication of the this downgrade, could lead investors to demand higher interest rates from the federal government and other borrowers, raising costs for governments, businesses and home buyers. But many analysts say the impact could be modest, in part because the other ratings agencies, Moody’s and Fitch, have decided not to downgrade the government at this time.

According to Felix Salmon, “the worst effects of a US downgrade, then, might not be felt for years, until the point at which a big state starts running into fiscal difficulties that are so serious that it faces difficulty repaying its bonded debt. At that point, in the olden days, the markets would expect some kind of federal aid; post-downgrade, they might just run chaotically for the exits instead, leaving the state’s citizens holding a bunch of paper worth less than half its face value (Salmon, 2011)”.  Another source of potential implication is derivatives markets, where investors and banks often collateralize their positions using U.S. Treasuries. If banks start demanding more Treasuries to collateralize the same exposure, investors could be forced to sell assets to come up with extra collateral, causing broader market declines (Bansal &Wilchins, 2011).

To add more, borrowing costs for companies with top ratings like Microsoft Corp and Exxon Mobil Corporation could drop, because triple-A rated debt may be even more attractive to some investors now, analysts said. Furthermore, state finances would drop especially; states that rely heavily on federal government spending such as Virginia and Maryland, which are home to many federal employees and defense contractors could suffer if Congress and President Barack Obama slice the federal budget (Bansal &Wilchins, 2011).

The criteria used by S&P to rate sovereign countries pertain to a sovereign's ability and willingness to service financial obligations to nonofficial, in other words commercial, creditors. A sovereign's issuer credit rating does not reflect its ability and willingness to service other types of obligations listed as follows: obligations to other governments (such as Paris Club debt) or intergovernmental debt, obligations to supranational, such as the International Monetary Fund (IMF) or the World Bank, obligations to honor a guarantee that does not meet our criteria for sovereign guaranteed debt (see "Rating Sovereign-Guaranteed Debt," published April 6, 2009) and, obligations issued by public sector enterprises, government-related entities or local and regional governments (S&P, 2011).

However, these criteria takes into consideration institutional effectiveness and political risks, economic structure and growth prospects, external liquidity and international investment position, fiscal flexibility and fiscal performance, combine with monetary flexibility.  And, these factors were assigned scores (political score, economic score, external score and monetary score). The S&P decision to downgrade US credit rating was in part based on the political score, which assesses how a government's institutions and policymaking affect a sovereign's credit fundamentals by delivering sustainable public finances, promoting balanced economic growth, and responding to economic or political shock. Treasury Department spokesman pushed back on the rating change, saying that S&P's analysis was flawed.

My personal opinion, there was some amount of flaws in the rating. There is a track record of the US federal government managing past political, economic, and financial crises; maintaining prudent policy-making in good times; and delivering balanced economic growth. The federal government makes about $250 billion in interest payments a year, so even a small increase in the rates demanded by investors in United States debt could add tens of billions of dollars to those payments (Applebaum & Dash, 2011). More so, a source familiar with the matter said S&P initially miscalculated the growth trajectory of the nation's debt, and then went ahead with its downgrade anyway. The source also said S&P didn't give enough credit for the debt-ceiling compromise, which paved the way for more than $2 trillion in spending cuts over the next 10 years (Riley, 2011). Furthermore, Moody’s said Tuesday that "failure to reach an agreement by the super committee would not by itself lead to a rating change for the U.S. government. Because, they viewed the US economy as strong compare to the world economy.

Conclusively, the S&P rating agency committed an epic fail during the housing bubble and committed another epic fail when they downgraded the US credit rating. How can the US credit rating be lowered and US companies and US states maintain their credit ratings? If the US government fails, S&P doesn't think corporations and states will fail? Their lack of logic and thought is staggering.  There is little guaranteed that the people who come into Washington will have any more altruistic motives. Most politicians spend their time trying to please a fraction of their local voters. The truth is that the financial collapse of 2008 shook a whole lot of people up. For decades we have enjoyed probably the most prosperous time in human history (at least for the western nations), but now the very foundations of the world economic system are coming apart. While the rich continue to get richer, the middle class is being destroyed and the poor are losing both their jobs and their homes. People are hurting. I don't believe that Washington ever showed such a disregard to negotiate for the common good before. Politics has always walked a fine line between trying to get reelected and actually trying to do what is right, and it seems pretty obvious we have long since overstepped that line.

LESSONS LEARNED FROM THE VARIOUS STOCK MARKET CRASHES

A stock market or equity market is a public entity for the trading of company stock or shares and derivatives at an agreed price; these are securities listed on a stock exchange as well as those only traded privately. There are many stock markets around the world, prominent among them are: United States (US) New York Stock Exchange (NYSE), US American Stock Exchange (AMEX), US National Association of Securities Dealers Automated Quotation (NASDAQ), Germany -Börse Frankfurt, United Kingdom - London Stock Exchange, Australia ASX, Shanghai SE Composite Index of China, Hang Seng Hong Kong, Mumbai Sensex India, Nikkei 225 Japan, Taiwan TSEC 50 Index and so on.

A stock market crash is a sudden dramatic decline of stock prices across a significant cross-section of a stock market, resulting in a significant loss of paper wealth. Crashes are driven by panic as much as by underlying economic factors. They often follow speculative stock market bubbles. Also, Stock market crashes are social phenomena where external economic events combine with crowd behavior and psychology in a positive feedback loop where selling by some market participants drives more market participants to sell (Burton, 2006). There are several stock market crashes since the inception of stock markets but, the major ones are:  the crashes in 1929, 1987, 1997, 2001, and 2007.

In October 29, 1929, the Dow Jones Industrial Average fell more than 11 percent on "Black Tuesday", with a record volume of 16 million shares traded. It heralded the beginning of the "Great Depression" of the 1930s. It did not surpass the 1929 average again until 1954 (Narayana, 2008).

News of a big U.S. monthly trade deficit on October 14 sparked the crash of 1987. The Dow took the first 100-point dive in its history on October 16, 1987 and again on October 19, "Black Monday". Wall Street lost 508.32 points taking the Dow down to 1,738.4. The crash wiped 22.6 percent off the value of the New York Stock Exchange, compared with 12.8 percent on the worst day of the 1929 Wall Street Crash (Narayana, 2008).

The crash of 1997 was emanated from financial turmoil in Asia that began in July when international currency speculators bet against the Thai baht helped trigger the biggest single-day point decline in the Dow Jones industrial average on Monday, October 27, 1997. Stock markets in Argentina, Mexico, and Brazil dropped between 13 and 15 percent. It spilled over into European markets on October 28. Tokyo's Nikkei 225 index fell 725.67 points or 4.26 percent to 16,312.69. Singapore's Straits Times Index ended 122.87 or 7.59 percent lower to 1,497.03(Narayana, 2008).

The crash of 2001 is another global stock crash was triggered by the September 11, attack on the United States. Investors across the world snapped up traditional safe assets like gold and bonds after the attack pummeled global stocks, shook the U.S. dollar and drove up oil prices. Main U.S. markets were closed after the attacks, which occurred just as the trading day was about to begin. After a delayed opening, Tokyo stocks slid to 17-year lows, with the Nikkei stock average losing 6.23 percent to 9,651.62 and breaching 10,000 for the first time since August 1984. European stock indices fell to their lowest levels since December 1998. London's FTSE 100 index shed 5.7 percent in its biggest one-day fall since the crash of October 1987, wiping $98 billion off the value of shares (Narayana, 2008).

On February 27, 2007, the Dow index fell 3.3 percent, or 416 points, following a collapse in Chinese stocks and weak U.S. manufacturing data. The Nikkei share average lost more than 3 percent and the FTSE 100 was down 116.1 points, or 1.85 percent. Mexican stocks lost 4 percent and Chinese stocks plunged nearly 9 percent, erasing about $140 billion of value in their biggest fall for a decade (Narayana, 2008)

The crash of 1929: Over the years market crashes have drove away many investors from stock trading. Starting with the 1929 stock market crashed once the First World War was over, the U.S. entered into a new era. It was a time of great enthusiasm, and optimism. This was a time when great inventions, like the airplane and radio, made pretty much anything seem possible in the 1920′s.

By around 1925, more and more people were getting involved in the stock market. Then in 1927, there was a very strong upward price trend. This enticed even more people to get into the stock market. By 1928, the stock market boom had taken off.

At this point, the stock market seemed like a place where virtually everyone thought they could become rich. The stock market had reached a fever pitch. Everyone thought they were an expert, and stocks were talked about everywhere. Tips were given by almost everyone. Lesson number one: Beware when the fever pitch is high, and everyone thinks they are a master of the stock market, getting richer by the day. Beware when everything seems too good to be true, and tips are given out by almost everyone (Rosenberg 2011).

            About this time, the Federal Reserve began to raise interest rates. Then in March of 1929, the stock market suffered a mini crash. In the spring of 1929, there were more signs that the economy could be headed for trouble. Steel production went down, house construction slowed down, and car sales tailed off. Lesson number two: Rising interest rates is a negative for the stock market. Also, when economic conditions begin to deteriorate, this is another negative (Kerkow, 2010).

        In the summer of 1929, the market surged ahead again, and all early warning signs were forgotten. From June through August, the stock market reached its highest price level ever. Nearly everyone thought it was a stock market heaven, which would never end. Lesson number three: When the market seems too good to be true, it probably is, and at the very least, a correction is coming soon (Kerkow, 2010).

 It is important to remember that markets do not go straight up forever. What we are seeing here is a classic example of mob psychology in full force. This is human nature at work, with the emotion of greed taking over many people.

 By August of 1929, many leading stocks were rising in price in dramatic fashion. This is called a climax run, and another warning sign of trouble up ahead for the market. Lesson number four: When leading stocks, after a big run up in price, make huge price gains in a relatively short period of time, this is a warning sign of the market topping(Kerkow, 2010)..

            The stock market peaked in September of 1929. At this point, heavy selling in big volume began to happen, and became somewhat common place. This is a major sign that smart money was leaving the market. There were five declines on heavy volume throughout September. All this selling was happening a full month before all hell broke loose in the stock market. Lesson number five: When general market declines on heavy volume begin to mount, it is definitely time to start selling your stocks. This is a major warning sign (Kerkow, 2010).

 The Dow declined nearly 90% from its peak in September, 1929, to its July, 1932 bottom. Many people lost their entire savings, and more. Savvy traders saw many signs of trouble, and had plenty of time to exit the market, before it really started to crash. Lesson number six: Those who knew the market warning signs, and acted, had plenty of time to exit the market, before it crashed, late in 1929. These stock market warning signs are just as valid today, as they were back then. Always keep an eye out for these warning signs, and act appropriately (Rosenberg 2011).

The crash of 1987: In the days between October 14 and October 19, 1987, major indexes of market valuation in the United States dropped 30 percent or more. On October 19, 1987, a date that subsequently became known as “Black Monday," the Dow Jones Industrial Average plummeted 508 points, losing 22.6% of its total value, The S&P 500 dropped 20.4%, falling from 282.7 to 225.06. This was the greatest loss Wall Street had ever suffered on a single day.

According to Facts on File, an authoritative source of current-events information for professional research and education, the 1987 crash “marked the end of a five-year 'bull' market that had seen the Dow rise from 776 points in August 1982 to a high of 2,722.42 points in August 1987." Unlike what happened in 1929, however, the market rallied immediately after the crash, posting a record one-day gain of 102.27 the very next day and 186.64 points on Thursday October 22. It took only two years for the Dow to recover completely; by September of 1989, the market had regained all of the value it had lost in the '87 crash (Itskevich 2002).

Many feared that the crash would trigger a recession. Instead, the fallout from the crash turned out to be surprisingly small. This phenomenon was due, in part, to the intervention of the Federal Reserve. According to Facts on File, “The worst economic losses occurred on Wall Street itself, where 15,000 jobs were lost in the financial industry (Itskevich, 2002).”

A number of explanations have been offered as to the cause of the crash, although none may be said to have been the sole determinant. Among these are computer trading and derivative securities, lack of liquidity, trade and budget deficits, and overvaluation.

What the 1987 crash ultimately accomplished was to teach politicians that markets heed their words and actions carefully, reacting immediately when threatened. Thus the crash initiated a new era of market discipline on bad economic policy. It also teaches investors that investing is a long-term processes not a one off transaction. At that time investors wouldn’t be able to sell their stocks when they wanted to sell their stocks, the market would over-correct, go down too far, and then bounce back later. To add more, as Warren Buffet ones said “invest in companies not market.”

The crash of 1997: The October 27, 1997 market crashed was called the mini-crash that was caused by an economic crisis in Asia. At that time, the Dow Jones Industrial Average plummets 554.26 points to 7,161.15. For the first time, the New York Stock Exchange activated their “circuit breakers” twice during the day eventually making the controversial move of closing the exchange early. Also, the NASDAQ lost 115.58 points (abcnews.com, 2011).

Investors may have realized Japan was becoming a bubble, but it was believed that the high level of collusion between the government and business could sustain the growth forever. But an inverted growth cycle perpetuated itself when landowning firms started using the book value of their land to buy stocks that they in turn used to finance the purchase of American assets (Rockefeller Center is 80% owned by Mitsubishi Estate Company). Like the prosperity of the Roman Empire, the prosperity of Japan proved to be its undoing as corruption began to spread throughout the political and business realms(investopedia.com, 2011)..

The bursting of the Asian bubble nearly took out the American economy as well, but the measures enacted after 1987 sopped the avalanche of program trading. We learned at least one lesson from all of these crashes: humans may overact frequently with small effects, but computers do it only once in a big way.

The crash of 2001: Following the worst terrorist attack in U.S. history on Sept. 11, the market plummeted on its first day of trading, the American Stock Exchange and New York Stock Exchange having been shut down for almost a week. The value of two present-day titans of banking and investments, JPMorgan Chase and Citigroup, dropped 6% by midday (Altman and Romero, 2011). The lessons learned here, are our resilience to handle unexpected events. Also, it is impossible to consistently guess the highs and lows of the stock market so don't even try. Instead, keep investing regular amounts in both bulls and bear markets. You need to be in the stock market over long time periods to reap its rewards. It increases investors CD mentality." In other words, investors must expect to lose principal sometimes or to see a loss or reduction in earnings. Investments are inherently volatile and unpredictable in the short-term. More so, a loss is a loss only if you sell. The lessons of history will be enormously helpful at such a time to provide a reality check on our emotional urge to dump all risky assets and go to cash.

Again, emerging markets hold potential to inject back into North American market. Markets are more global and connected than in 1987 and 1997. Now, no market is immune to significant local event. Since 1987 and 1997 banks have become more experienced at handling global market crisis.

The crash of 2007: In October 2007 marked another great recession since the 1929 depression. The Standard and Poor (S&P) 500 declined 57% from its high in October 2007 of 1576 to its low in March 2009 of 676; many indicators of credit risk such as the "Ted Spread" or the option adjusted spread (OAS) on corporate bonds reached record highs (investopedia.com, 2011).

Following the bursting of the tech bubble and the recession of the early 2000s, the Federal Reserve kept short-term interest rates low for an extended period of time. This coincided with a global savings glut, as developing countries and commodity producing nation’s accumulated large financial reserves. As these excess savings were invested, global interest rates declined to record low levels. Frustrated with low returns, investors began to assume more risk by seeking higher returns wherever they could be found. For several years, global financial markets entered a period which came to be called the "Great Moderation" due to the above-average returns and below-average volatility demonstrated by a wide variety of asset classes (Beatie, 2011).

In the United States, the Great Moderation coincided with a housing boom, as prices soared (particularly on the two coasts and in cities such as Phoenix and Las Vegas.) Rising home prices led to rampant real estate speculation, and also fueled excessive consumer spending as people began to view their homes as a "piggy bank" that they could extract cash from to fuel discretionary purchases. As home prices soared and many homeowners "stretched" to make their mortgage payments, the possibility of a collapse grew. However, the true extent of the danger was hidden because so many mortgages had been securitized and turned into AAA-rated securities (investopedia.com, 2011).

When the long held belief that home prices do not decline turned out to be inaccurate, prices on mortgage-backed securities plunged, prompting large losses for banks and other financial institutions. These losses soon spread to other asset classes, fueling a crisis of confidence in the health of many of the world’s largest banks. Events reached their climax with the bankruptcy of Lehman Brothers in September 2008, which resulted in a credit freeze that brought the global financial system to the brink of complete collapse.

Unprecedented central bank actions combined with fiscal stimulus (notably in the US and China) helped ease some of the panic in the market place, but by late winter 2009, widespread rumors surfaced that Citigroup (NYSE:C), Bank of America (NYSE:BAC), and other large banks would have to be nationalized if the global economy was to survive. Fortunately, the aggressive actions by governments around the world eventually helped avoid financial collapse, but the credit freeze forced the global economy into the worst recession since World War two (investopedia.com, 2011).

The credit crisis and accompanying recession caused unprecedented volatility in financial markets. Stocks fell 50% or more from their highs through March 2009 before rallying more than 50% once the crisis began to ease. In addition to stocks, most fixed income markets also displayed unprecedented volatility, with many corporate bond markets at one point forecasting bankruptcies at a level not seen since the Great Depression. Oil fell 70%, then doubled as the financial system stabilized (Beatie, 2011).

The events of the housing bubble and credit crisis are likely to resonate with consumers and investors for years to come. In many countries (including the U.S.) consumers remain heavily leveraged and many homeowners are "underwater." As consumers deleverage and repair their finances, their purchasing patterns will be permanently altered. Many developed market countries have also seen a substantial deterioration in their fiscal position. While government actions helped prevent worst-case outcomes from the credit crisis, large budget deficits now represent a structural problem that may take decades to solve (Investopedia.com, 2011).

Finally, the lessons learned so far from this crash is that investors have experienced the most volatile and frightening markets of their life. Positive lessons, such as the importance of diversification and independent analysis can be taken from the crisis, but there are also emotional affects that must be considered. In particular, investors must remember that the events of the crisis were unusual and are unlikely to be repeated; while excessive greed in the financial markets is inappropriate, so too is excessive fear. Investors that can incorporate the lessons of the credit crisis without having their emotions unduly influenced will be best positioned for future investment success.

Conclusion: Sudden stock markets crash leads to confusion and chaos and the stockholders start selling stocks at a random rate. Psychology of the shareholders changes and a massive change in the crowd behavior become prominent during a market crash .A stock market boom can come to an end with a market crash. So, it is prudent to keep an eye on the market trends First off, we should point out that most market volatility is our entire fault. In reality, people create most of the risk in the market place by inflating stock prices beyond the value of the underlying company. When stocks are flying through the stratosphere like rockets, it is usually a sign of a bubble. That's not to say that stocks cannot legitimately enjoy a huge leap in value, but this leap should be justified by the prospects of the underlying companies, not just by a mass of investors following each other. The unreasonable belief in the possibility of getting rich quick is the primary reason people get burned by market crashes. Remember that if you put your money into investments that have a high potential for returns, you must also be willing to bear a high chance of losing it all. Another observation we should make is that regardless of our measures to correct the problems, the time between crashes has decreased. We had centuries between fiascoes, then decades, then years. We cannot say whether this foretells anything dire for the future, but the best thing you can do is keep yourself educated, informed, and well-practiced in doing research. To crown it all, the Security and Exchange Commission (SEC), Congress, and any other concern entities should be proactive rather than reactive in dealing with issues in order to prevent future market crash.

References:

Altman, A & Romero, F. (2011). Top 10 Dow Jones Drops. Retrieved on May 1, 2011 from: http://www.time.com

Beattie, A.  (2010). Market Crashes: Housing Bubble and Credit Crisis. Retrieved on April 28 from: http://www.investopedia.com  

Burton, M. G. (1973). A Random Walk Down Wall Street (6th ed.). W.W. Norton & Company, Inc. United States.

Itskevich, J. (2002). What Caused the Stock Market Crash of 1987? Retrieved on April 29, 2001 from: http://hnn.us/articles/

Kerkow, G.E. (2010) Lessons Learned- The 1929 Stock Market Crash

Narayana, (2008).Fact box: major stock market crashes. Retrieved April 27, 2011 from http://www.reuters.com/article/2008/01/21/us-market-crashes

Ram, A. (2011).Global Stock Market Crash. Retrieved on April 30, 2011 from: http://abcnews.go.com/Archives/video/

Rosenberg, J.  (2011). The Stock Market Crash of 1929. Retrieved on May 1, 2011 from: About.com Guide

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How Requirement of Sarbanes-Oxley have Impacted Management

The Sarbanes-Oxley Act (SOX) of 2002 significantly expanded the rules for corporate governance, disclosure, and reporting. It emphasizes the critical role of internal control over financial reporting within companies in an effort to enhance their accountability and restore investor confidence after the huge financial and accounting scandals which saw the end of Enron and Arthur Anderson. Specifically, SOX is intended to enhance financial disclosures and management assessment of internal control in line with the related Securities and Exchange Commission (SEC) rules. Auditing Standard No. 2 established by the Public Company Accounting Oversight Board (PCAOB) requiring management of a public company to report annually on the effectiveness of the company's financial statement. Under the new reporting requirements, investors and other users of financial statements may be required to make investment and credit decisions based on an independent auditor's report that may have differing opinions.

This paper examines section 302 - management assessment of disclosure controls, section 404 - management assessments of internal controls over financial reporting and section 409. These three sections require companies to have a "timely" reporting of material events that have an impact on the financial reports and how they impact management. Disclosures on information of risks and uncertainties have become an increasingly important part of financial reporting (Linsmeier and Pearson, 1997). At the individual level the penalty for violating the provisions of Sarbanes-Oxley are significant. The most notable of penalties is reserved for Chief Executive Officers (CEOs) and Chief Financial Officers (CFOs) who are required to attest to the validity of the firm's financial reports. Individuals that violate this provision, either knowingly or unknowingly are subject to up to $5 million in fines and/or 20 years in prison (Claypool, Tackett, and Wolf 2004)

It is important to note that in conjunction with the management requirement to report on the effectiveness of internal control over financial reporting, it is also mandatory to make all relevant assessments on the disclosure of the control policies and procedures designed and implemented in respect of the operating effectiveness of the company and its financial statements. The company's independent auditors are also required to issue a report on the operating effectiveness of the internal control implemented by management and how they impact the financial reports. This includes both an opinion on management's assessment of the internal control policies and the effectiveness of their operation. The auditing requirements also highlight the importance of the concept of material weaknesses in the internal control and their impact on financial reporting. Both management and the independent auditor are mandated to prepare a public report on any material weaknesses in internal controls on the financial reports that exist at the fiscal year end. A material weakness is a deficiency or combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the company’s financial statements will not be prevented or detected on a timely basis. The existence of a single material weakness requires management and the independent auditor to conclude that internal control over financial reporting is not effective.

With the passage of SOX, it was believed that the SEC and investors would possess a greater ability to hold a corporation's officers accountable for financial and accounting misdeeds. Thus, by certifying, the CEO and CFO have assured investors that the report does not contain any untrue statements of material fact that would make the statement misleading (Bass, Slavin, and Vogel, 2011). In order to maintain this requirement, management is to report on the effectiveness of internal control over financial reporting. The importance of internal control and the need for internal control standards are issues that have been addressed by regulators and the profession. Prior to the fraudulent financial reporting practices and resulting decline in investor confidence in the early 2000s, the disclosure of internal control deficiencies was not required in the audit report. Audit standards required the auditor to report on significant internal control deficiencies to the audit committee and to use the assessment of the control risk to determine the nature, timing, and extent of substantive testing. SOX mandated new disclosures about and assessments of internal controls. Speaking in terms of specifics, Section 404 requires management to annually disclose its assessment of the firm's internal control structure and to include the corresponding opinion by the firm's auditors on management's assessment of the firm's internal control, as well as the auditor's opinion on the internal control structure of the firm. Prior literatures have provided limited empirical evidence on the impact of the internal control reporting requirements of SOX on investors' evaluations of firms (Bierstaker, and Wright, S. 2004).

In an investigation of the market reaction to internal control deficiency disclosures, we found that firms reporting internal control deficiencies exhibit significantly high risk and cost of capital relative to firms not reporting internal control deficiencies. In contrast, other findings using different sample, design and cost of capital estimation find no association between internal control weaknesses and cost of capital. Our study highlights issues addressing the impact of SOX legislation by examining the impact of internal control deficiency disclosures on the investment decisions of individual investors.

Accounting policy makers consider investors an important user group for accounting information; as a result of this, most empirical test of the impact of accounting information on investors have taken a "macro" approach, investigating the market's aggregate response to accounting data, relying on the capital asset pricing model. However, a few prior studies have experimentally investigated whether risk judgments and investment decisions of individual investors are affected by the variables noted in portfolio theory (variance of returns and covariance of returns with the market return) and/or accounting risk measures. It is important to note that when accounting information and market measures are in conflict, the participant's risk judgments correspond with accounting measures rather than market measures (Bedard, and Graham, 2002). Furthermore, in a study examining how investors perceive risk, both the decision-theory variables (probabilities and outcomes) and behavioral variables are important in explaining investors' risk judgments. Specifically, there is a demonstration that potential loss outcome has an indirect, as well as a direct, effect on risk perceptions. Higher potential loss outcomes lead to greater perceived risk. Additionally, higher potential loss outcome has an indirect effect on perceived risk via its influence on behavioral variables that measure a risky item's perceived controllability and voluntariness, as well as the amount of worry and catastrophic potential associated with the item or investment (PCAOB 2005).

However, management should note how investors process and evaluate accounting information in studies utilizing experimental tasks. Management, auditors and investment analysts should make risk judgments given differences in opinions regarding management's assessment of internal control and the auditor's assessment of internal control in an experimental task. Specifically, the auditor examines the effect of internal control deficiencies on investment analysts' assessment of the financial strength of the company and the willingness to recommend the stock for purchase to clients. When the auditors give an adverse opinion on the effectiveness of internal control over financial reporting because of the existence of a material weakness, we expect to find that investment analysts would assess a higher risk for the firm than when the auditors give an unqualified opinion on internal control over financial reporting. Furthermore, we expect that investment analysts would be less likely to recommend firm stock to a client when there is an adverse opinion on the effectiveness of internal control over financial reporting because of a material weakness than when there is an unqualified opinion on financial statements and on internal control over financial reporting.

Again, internal control over financial reporting is a process designed and maintained by a company’s management to provide reasonable assurance about the reliability of financial reporting. Effective internal control over financial reporting is vital to the proper recording of transactions and the preparation of reliable financial reports. An effective internal control process is comprehensive and involves people at all levels throughout a company, including those who keep accounting records, prepare and disseminate policies, and monitor systems, as well as people in a variety of operating roles. In addition, the process is influenced by a company’s board of directors and its audit committee, which has responsibility for oversight of the financial reporting process. Under Section 404, a company’s management must assess the effectiveness of internal control over financial reporting as of the company’s fiscal year-end. The independent auditor will then report on management’s assessment, and on the effectiveness of the company’s internal control over financial reporting.

Effective internal controls are fundamental to investor confidence in financial reporting because they help to deter fraud and to prevent inaccurate financial statements. With more than half of U.S. households investing in the capital markets, either directly or through retirement funds, the new requirements of the SOX are expected to have a significant beneficial impact on investment and the capital markets. One of the most visible changes that investors have noticed is the new reports by management and the independent auditor on a company’s internal control over financial reporting. A primary purpose of this publication is to help investors and other financial market participants better understand and interpret these new reports, which will be provided in addition to the independent auditor’s report on the company’s external financial statements to Americans (AICPA 2002).

To add more, section 404 of the Sarbanes-Oxley Act institutes a new reporting model that will require management’s assessment of internal control over financial reporting and the related auditor’s report on internal control over financial reporting to be included in a company’s annual report on Form 10-K filed with the SEC. The SEC strongly encourages registrants to include the internal control reports in annual reports to shareholders as well, and has indicated that there will be rulemaking in this area.

The new reports that investors will see are the following:

• Management’s report: Management will state its responsibility for maintaining adequate internal control over financial reporting and give its assessment of whether or not internal control over financial reporting is effective. According to the rules, management cannot state that internal control over financial reporting is effective if even one material weakness exists at year-end.

• Auditor’s report. The independent auditor will evaluate and report on the fairness of management’s assessment. The auditor also will also perform an independent audit of internal control over financial reporting and will issue an opinion on whether internal control is operating effectively as of the assessment date (i.e., the company’s fiscal year-end). If one or more material weaknesses exist at the company’s fiscal year-end, the auditor cannot conclude that internal control over financial reporting is effective.

As in the past, the independent auditor will also issue an opinion on whether the company’s published financial statements are presented fairly in all material respects in accordance with generally accepted accounting principles (GAAP). This report may be combined with the auditor’s report on internal control over financial reporting, or it may be presented separately.

Management is also required to assess internal control deficiencies. When an internal control deficiency is identified, management and the independent auditor will evaluate its significance and determine whether it constitutes a control deficiency, a significant deficiency, or a material weakness. Deficiencies that are less serious than a material weakness (i.e., control deficiencies and significant deficiencies) are required to be disclosed to the audit committee and/or management, and management and the independent auditor must evaluate less serious weaknesses to determine whether, when taken together, they result in a material weakness. All identified material weaknesses that exist at the company’s fiscal year-end must be disclosed in the public reports issued by management and the auditor. Although not required by Section 404, some companies may also choose to disclose significant deficiencies. If one or more material weaknesses exist at the company’s fiscal year-end, management and the auditor must conclude that internal control over financial reporting is not effective (Davis, 2006).

The Public Company Accounting Oversight Board (PCAOB) has defined a material weakness as a “significant control deficiency, or combination of deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected (PCAOB, 2005).” A material weakness does not mean that a material misstatement has occurred or will occur, but that it could occur.

Although the law requires that management disclose material weaknesses, they provide no specific guidance about the content of those disclosures. However, both the SEC chief accountant and the PCAOB chairman have stated publicly that they expect management’s report to disclose the nature of any material weakness, in sufficient detail to enable investors and other financial statement users to understand the weakness and evaluate the circumstances underlying it. The PCAOB standard also requires that the independent auditor’s report provide specific information about the nature of any material weakness and the actual and potential effect on the company’s financial statements. Investors and other financial statement users should evaluate each material weakness to understand the nature, cause, and potential implications of the weakness.

It is important to note that a company can report a material weakness in internal control over financial reporting and still receive an unqualified, or “clean,” financial statement opinion from the independent auditor. Whether management or the auditor identifies a material weakness, management continues to be responsible for the preparation of complete and accurate financial statements. Therefore, management should take whatever steps are necessary to compensate for the material weakness in the financial statement preparation process. By expanding the scope of testing of account balances or altering the audit approach in the area of weakness, the auditor may be able to conclude that the company’s financial statements are fairly stated and thus issue an unqualified opinion (PCAOB 2005).

Internal control reporting provides additional information to the marketplace. The expectation is that underwriters, analysts, rating agencies, lenders, and other market participants will consider internal control reporting in their analysis and evaluation processes for investment purposes.

Timely, has been interpreted under section 409 of SOX to be two working days or less. This section also states that each issuer must disclose any information concerning material changes in the financial condition or operations of the company on a current basis. As soon as a company declares a material event, they must also document it before they are allowed to claim that they have adequate process controls under section 404 (One Hundred Seventh Congress 2002). Most of these material events normally occur between the date of preparation of financial statements and the date of their approval by the management. Such events must be reflected in the financial statements of a firm, in order to comply with the requirement of section 409. It would help to ensure relevance and reliability of the financial statement. Also, it would help build investors’ confidence on the “true and fair view” of its financial position. On the other hand, there are some events which are significant but non-material. These events need not be reflected in the financial statement but, has to be included in the footnote of a firm. To crown it all, the independent auditors has to determine whether an item is material or non-material based on the effect on investors.

Conclusion

In response to recent corporate scandals, Congress passed the Sarbanes–Oxley Act of 2002 (SOX) which, among other things, requires that the management assess the effectiveness of a company’s system of internal controls. The assumption implicit in this requirement is that the new internal control opinion provides investors with value-relevant information (PCAOB 2005). I believe through the creation of SOX as an ongoing management requirement, companies will learn from their evaluation process and remediate identified deficiencies, which should result in more reliable financial reporting and greater investor confidence. Even with these new requirements in place, it is possible that management fraud or errors will occur and not be detected since we have inherent risks. This may be due a dominant management team or a fraudulent collusion by employees. The independent auditor assesses financial statement of the prior year therefore they are limited by inherent risks. Internal control over financial reporting is intended to provide a reasonable assurance about the reliability of the financial reports. This is a high level of assurance, but it is not absolute. As the PCAOB standard recognizes, no system of internal control is absolutely safe from human error or from manipulation and collusion. Even effective internal control over financial reporting cannot offer absolute assurance that a company is free of fraud or that misstatements in financial reporting will always be prevented or detected on a timely basis. Investors and other financial statement users should also understand that the reports on internal control over financial reporting issued by management and the independent auditor do not provide any form of assurance on the soundness of a company’s business strategies or its ability to achieve desired financial goals. The intended users of the financial reports should also understand that it is not the auditors’ primary responsibility to prevent and detect fraud but may act as a deterrent as they have to express an opinion and give a reasonable assurance that the financial statements as a whole are free from material misstatements.

Also evidence suggested that an adverse audit opinion on internal control over financial reporting provides incremental value-relevant information to investors. This information is not provided in the financial statements and the audit opinion. Specifically I found that an adverse audit opinion on internal controls over financial reporting relative to an unqualified opinion is significantly associated with investors assessing a higher risk of financial statement misstatement, higher risk of a future financial statement restatement, higher information asymmetry, lower financial statement transparency, higher risk premium, higher cost of capital, lower sustainability of earnings, and lower earnings predictability. Overall, I support the fact that the auditor’s opinion on the internal controls over financial reporting provides investors and other financial statement users with relevant information that will help them make prudent investment and economic decisions.

References

American Institute of Certified Public Accountants (AICPA). (2002). The Consideration of    Fraud in a Financial Statement Audit. SAS No. 99 New York, NY AICPA

Bass, S. L., Slavin, N. S., & Vogel, G. M. (July, 2011). Sarbanes-Oxley's CEO and CFO Certification Requires Scienter to Protect Investors. CPA Journal; Vol. 81 (7) 62-66,

Bedard, J.C. and Graham, L.E. (2002). The effects of decision aid orientation on Risk Factor   Identification and Audit Test Planning", Auditing: A Journal of Practice and Theory, pp. 39-56. Claypool, G., J. Tackett, and Wolf, F. (2004), Sarbanes-Oxley and Audit Failure: A Critical Examination, Managerial Auditing Journal: Vol. 19, (3) 348-350. Davis, J.T. (2006), Experience and auditors' selection of relevant information for preliminary             control risk assessments, Auditing: A Journal of Practice and Theory, pp. 16-37.
Linsmeier, T. and Pearson, N. (1997). Quantitative disclosures of market risk in the Securities               and Exchange Commission release.  Accounting Horizons, Vol. 11. pp. 107-35. One Hundred Seventh Congress of the United States of America. (January 2002). Retrieved on November 25, 2011 from Find Law Website: www.news.findlaw.com/hdocs/docs/gwbush/sarbanesoxley PCAOB (2005), Public Company Accounting Oversight Board Issues Guidance on Audits of             Internal Control. Retrieved on November 24 from PCAOB Website; www.pcaob.com/News_and_Events/News/2005/05
Bierstaker, J.L. and Wright, S. (2004), Does the Adoption of Business Risk Audit Approach    Change Internal Control Documentation and Testing Practices? International Auditing Journal, Vol. 8, pp. 67-78.