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Subprime Merchandise Cards

Accounts receivable represent amounts due from customers who have purchased merchandise on credit and who have agreed to pay within a specified period or when billed by a company. Since all accounts receivable represent a portion of purchased merchandise on credit it is a given that some of the income represented within the account will not actually be received by the company.  Due to this business phenomenon it becomes necessary for any company to account for this loss on the balance sheet. Commonly named bad debts expense this has become a major focal point in recent financial history because of the credit crisis in the subprime mortgage industry.  For companies that issued subprime mortgages there is an internal assumption that a large portion of the accounts receivable or credit debt will not be repaid. The reason a company can handle such a large amount of risk is due to overall sales volume. By having a large clientele base revenues can be increased enough to cover the overall loss, but as recent history shows one shift in the current economic climate can have drastic consequences to not just one industry but to the global economy depending on how leveraged the world economy is to any one economic environment. In the case of the US mortgage market we found that it was not only the mortgage companies but all of the subsidiary investors which took on a portion of the risk by chasing large rewards, these risks created an overly leveraged market. As investors continued to build housing in the hope of riding increases in housing prices they created an excess in housing inventory, which in turn devalued the houses on the market as well as those being built. When localized household wealth declined mortgage lenders lost capital and the ability to fund refinancing and the necessity for an increase in the adjustable rates on existing home loans. Since there was already too much risk inherent in the market those borrowers who were questionable to begin with defaulted at an ever increasing rate until the market collapsed around them. These defaulted borrowers have to be accounted for on the books, and this is what we will take a closer look at.

When a purchaser buys merchandise on credit certain entries must be made to the accounting ledger. Let’s say NEC Inc. sells some coffee cups on credit. If we assume the cups were already produced and in inventory then Cost of Goods Sold (COGS) is debited for the manufacturing cost and Inventory is credited for the same amount, say 7,000 dollars. This takes care of the internal cost of producing those cups. Next Accounts Receivable is debited $10,000 and the Sales account is credited $10,000. Now NEC Inc. has transferred the COGS to the customer but instead of increasing cash flow it has only increased the money owed in the form of accounts receivable. Like your average consumer credit card when goods or services are sold from one company to another some form of payment timeline is agreed to, but for ease of use we will assume the retailer who purchase the cups agreed to pay the total amount in full that the end of the month. However, just few days later a natural disaster strikes and not only is the retailer completely destroyed but all possible liable parties are affected to the point where they cannot pay their debts. Now NEC Inc. has 10,000 dollars the on the books that should have become cash flow but instead will never be recouped.

In this situation NEC Inc. has very little choice but to move the debt into a Bad Debt Expense account. This type of account is called a contra account in that it is reported as a subtraction on the asset portion of the balance sheet. Under the asset portion of the balance sheet an entry is logged under allowance for bad debts while bad debts expense is debited. This is of course is not a write off, but it is unlikely that a company would write off the debt until the books have been closed that the end of fiscal quarter. When the write-off entry is noted it will come in the form of decrease to the accounts receivable account and an increase to the allowance for bad debt. In the case of NEC Inc. the initial entry would include a debit of -$10,000 to Allowance for Bad Debts and a credit of -$10,000 to Bad Debts Expense. Then debit of -$10,000 to Accounts Receivable and a debit of +$10,000 to the Allowance for Bad Debts. The allowance for bad debts account is a valuation account because its credit balance is subtracted from the debit balance off the Accounts Receivable. If, on the other hand, a company wishes to use the direct write-off method then a debit is entered under Bad Debts Expense and a credit is placed under Accounts Receivable for the amount of the bad debt. By correctly recording bad debt a company ensures that its net income, ROI, ROE, and liquidity measures remain accurate.

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Article Source: ArticlesBase.com - Matching Receivables: How to Account for Bad Debt

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2008 Subprime Crisis

Question: Understanding the Subprime mortgage crisis?

http://genxfiles.com/2008/09/21/the-mess-that-were-in/

This blog did a great job of explaining the crisis, but how do we get back on track?

Answer: Everybody is looking for a quick fix. A fix which involves little or no pain. Such a fix doesn't exist no matter what McCain or Obama says. There will be pain. Lots of it. Anybody who says there's an easy way out of this is lying to you. Housing prices will plummet as loans continue to be unavailable and as foreclosures continue. More people will be thrown out of their homes. Banks will continue to fail. They will be stuck with homes they cannot sell at a price to cover the mortgage. Deflation may occur. Hell, it's happening now with the drop in oil, gas, homes, gold, metals, grains and other commodities. The economy will slow. Interest rates will drop further. Unemployment will rise. Eventually (a year or two from now) a bottom will be reached. Interest rates will be so low and housing will be so cheap, that people will be able to buy them. At least those with the best credit records. The economy will begin to pick up again. Jobs will be created again. But this will all take time and pain. The government needs to let it unwind. I fear they won't and will just delay a more natural recovery.

Inside the US subprime crisis 01 April 2008

Subprime Financing

Question: how does citibank writes off $XYZ billions work?

I mean I read in many places that major banks write off bad-debt(subprime loan etc...) . Is the real loss to those banks. From what I know, those banks intern have sold those mortgages as some kind of securities or bundles, which are at some point or other finally sold to individual investors. So how do those mortgage loans contribute to the $XYZ Billion write-off. The loss should be to the individual investors not the finance companies. Can somebody explain?

Answer: The bank also bought thos eCDO and MBS to park their cash. Banks seat on billon of cash. When they give you a 6 monbth CD at 3%, the money to pay your CD interest come from their own investment. Banks also set up off balance sheet entities that bought these CDO and MBS, and the bank gaurantee repayment on these off balance sheet arrangement. The write off comes from the issue or marked to market. As there is no liquidity for these type of investments (i.e. it is not being traded daily, nor even monthly) they have design complicated calculations to estimate the fair value of the CDO and MBS. The problem arised when the market froze itself and no one was buying these securities and the deliquency rate was increasing. The banks were stuck with these investments, with increasing delenquency rate and they had to market them down on their balance sheet (eventually that does not mean that the cash flow generated by the investment is bad). If noone can put a fair value to the security you have to writte it off to $0.
Hope this help
PS: bank buy each other bonds and securities all the time. That's how they lend each other.

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