The financial accident we are in today was not caused by mortgages or housing, although they were both catalysts. The real suspect is an accounting rule called "Mark to Market". What is this rule and why does it exist?
Well. Lets go back to the Enron fiasco. As is well known, many people lost their life savings when Enron other clubs crashed and burned. It was revealed that these clubs falsely made their books look good by artificially inflating their assets. Both the communal and Congress wanted more transparency in business and passed the Sarbanes-Oxley Bill. One of its provisions called for "Mark to Market" accounting. This concept means that when a business values its assets on financial disclosures, they should be valued as if the business would sell that asset today. If the business fails to do so, the officers can go to jail. What's the problem? Before I discuss how this affected banks, let us look at an example of Long Island houses or any other house.
Let us dream that you own a house in a neighborhood where all houses are selfsame and are all worth about 0,000. Unfortunately, your neighbor has a personal accident and needs money right away. Because this someone is under duress, the home is sold for 0,000. Does that mean your home or other houses in the neighbor are worth 0,000? Of procedure not, but if you were a publicly traded company, by law you would have to list your house at a value of 0,000, not the 0,000 you would want if you sold it. How does this principle apply to banks?
Let us say we resolve to start a bank, call it Xyz bank. We raise million to start. That means our capital list has million. Remember, banks make money by taking in deposits and paying low rates of interest and lending it out at higher rates of interest. When we open the doors to Xyz bank, we take in million in deposits. We turn colse to and take that million and lend it as mortgages. Our capital list is million and our loans are million. That is a ratio of 15:1. Under banking laws, this is a perfectly standard ratio.
Xyz bank does not make risky loans. All our mortgages go to people who put down at least 20%, a reputation score over 800 (which is almost perfect), have assets in bank accounts that are 10 times the monthly mortgage payment (normal is two months) and the monthly mortgage payment is only 10% of the borrower's monthly revenue (40% is normal).
We do this and our loans accomplish perfectly. We make lots of money. Nobody is late, every one pays not only on time, put even early. Our depositors and borrowers love us and we are development lots of money. We break out the champagne as our stock prices and our profits rise.
Now the housing accident hits and real estate values decline. Even though our customers continue to pay on time and every loan is performing perfectly, we must re-assess our mortgage briefcase to list for the decline in real estate values. Under mark to market accounting, since real estate values have gone done, the mortgages on the houses become riskier, even though every person is paying on time. We must sell out the value of our mortgages from million to million to reflect that the mortgages are riskier. It is a paper loss, we do not write a check, no defaults, no late payments and no bad business decisions. Still we must reflect this million dollar paper loss by reducing our capital list by that same million. Our capital account, which was million,is now valued at million.
Now we are in trouble. We have million of mortgages excellent and only a million dollar capital list (on paper). The percentage is now 30:1 Our ratios are now out of banking compliance. The Fdic puts on a watch list, the Securities and exchange Commission (Sec) is asking questions. Cnbc is now reporting that we are in trouble. What do we do? We have to raise an additional million dollars to raise our capital list back to million. This is unlikely because nobody will invest in a bank that is on Fdic watch list and being investigated by the Sec.
The other selection is to sell assets, like the excellent mortgages. Like your neighbor in the first example, we need to raise cash fast, so we sell the excellent mortgages quickly. This will additional sell out the value of the mortgages we have on the books. It is a vicious cycle as our bank starts to spiral down. What did Xyz bank do wrong? The rejoinder is nothing. This was all caused by the mark to market pricing requirement. The question does not stop with Xyz Bank.
The fire sale that we just had on our mortgages males things worse for the banks that bought our mortgages for a great price. Under Mark to Market, the mortgages we just sold must be used as comparable that other financial institutions use to value their assets. This is how the question spread and things went bad so fast. Other good institutions had to de-value their loans and just like Xyz Bank, were over leveraged. This caused a chain reaction, caused be a well intentioned, but harmful accounting rule.
As a ensue of this chain reaction, financial institutions fold, sell or freeze credit. The life blood of our economy is choked off, which has caused this mess. It is clear that the mark to market rule has to be modified as it relates to loans. This will go a long way to help us out of this crisis.
Mark to market - The Real calculate Behind the Financial urgency