How "Mark-To-Market" Accounting Changes Have Affected The Economy
The other day I had a conversation with a friend regarding what feels like (hopefully!) the recent re-direction of the general economy. My position was that a lot of it was based on an accounting rule known as "Mark to Market" that had been enforced up until just recently, but has now been relaxed. Below I'll outline the concept of Mark to Market and why I believe it was a good move to make the change. Whether you agree with me or not, at least we can hope that things continue to move in what appears to be a better direction...
If you have been paying any attention to the news lately (and it is probably
safe to say that the majority of people with a Portland home loan have been),
you have probably heard a lot of discussion (debating) about the term "Mark to
Market" and whether or not changes need to be made to it.
So what exactly is Mark to Market and why does it matter? Is this going to have an affect on the housing market in general, and more importantly, how might it directly affect your Portland home mortgage?
We are going to do our best to give a summary of it below so you can better understand what it is, and more significantly, comprehend how it has played such a significant role in our existing economic crisis, not to mention the Portland mortgage market. You may be surprised to see that this accounting stipulation (i.e. law) has a whole lot more to do with the current economic down turn than perhaps anything else.
Before we even look at how Portland mortgage rates get affected, we are first going to discuss why Mark to Market was even created
To fully understand Congress' inspiration behind making this accounting rule, we need to go back and look at the stock market crash 2000-2002.
At that time, prior to the creation and implementation of this rule, companies such as Enron and Arthur Anderson found methods of 'cooking their books' to make their balance sheets appear a lot healthier than they truly were. This, in turn, caused their stock prices to be falsely high,playing into the creation of the 'bubble' that, as we all know, eventually popped. When that occurred, a lot of people lost a whole lot of money. To suggest they were unhappy is more than an understatement. Something neededto be done.
The concept of "Mark to Market" accounting was created in an effort to make things significantly more transparent and to be sure of fair valuation of companies and all their assets. To summarize, what it means is that all assets are required to be valued just as if they were to be sold on a daily basis. For those mavericks who chose not to do this conservatively, they put themselves at risk for possible jail time.
Let's now have a look at how this rule can cause a problem affecting the whole economy, including Portland mortgages.
When you consider the huge amounts of money handled by banks - and the wide (and odd) variety of financial instruments they use, - it can be difficult to attempt to get one's mind around what they do. It will be easier to illustrate how this accounting strategy works using an analogy more approachable to the rest of us.
Let us say you live in a neighborhood and all the houses are worth about $200,000. Let's also imagine that your neighbor owns his house free-and-clear.
Unfortunately, your neighbor has some sudden major medical expenses and has to sell his house to pay forit. He is in need of his money right now and doesn't have the luxury to shop for a Portland refinance, and he is not in any position to wait for the best price he can get. Instead, he sells the house for $150,000 to get rid of it fast, even though it is clear that the house is worth considerably more than that.
If you happened to live two houses down in an identical house, does the fact that your neighbor's house sold for $150,000 mean your home just lost 25 percent of its value? Of course it doesn't. If you decided you were going to sell your house, you would take the time needed and get the fair market price for it; you would not be forced into a "fire sale" situation like your neighbor.
On the other hand, if you were a public company and had to by law to go by the Mark to Market accounting rules, you, as well as all your neighbors, would now be forced to claim that the home you live in was now only worth $150,000 and not the $200,000 everyone knows to be the real value.
Let's see how this would apply to a bank.
Allow me to present some more hypotheticals.
Let's pretend you decided to begin a new bank, we're going to call it YOUR BANK. You begin with a $2 million initial investment to get Your Bank started. Your strategy to make money as a bank is to take in people's money as deposits, and pay then a low but safe rate of return on that, and then use the money to create loans, such as Portland home loans, that will pay you a a higher rate than you are paying to your depositors. The difference between the two rates is the profit you keep.
Let's say that out of that initial $2,000,000 in deposits, we create $30,000,000 worth of loans. Our Capital Ratio (the ratio of loans to actual capital on hand) is at a comfortable 15:1 ($15 million in loans for every $1 million in deposits). This ratio is completely acceptable by banking standards.
We are going to say that you run an extremely conservative bank, and the Portland loans Your Bank agrees to make are limited to those of only the very highest standards. You require a 30% down-payment (industry average is 20 persent, and sometimes even less than that), you want a credit score of 800 (this would be a VERY high credit score), you require full documentation on all income and assets and you will only allow a debt-to-income ratio of 10 percent (40% is the industry norm).
It is exceedingly clear, Your Bank will only engage in an excellent quality Portland loan. And it shows. All of your borrowers always pay on schedule, no one is unhappy and Your Bank is making money. This makes Your Bank stock price go higher and higher.
All of a sudden, the Portland real estate market starts to slow down a lot and go soft, and Portland home values start dropping (but your borrowers continue to make all their payments on time, no problem).
The problem is, with the systemic drop in home values, you are forced to re-assess the value of your loan portfolio. Now, rather than the loans being 70% of the value of the home, they're now at 90% (your equity position in the home just went down considerably). This means these loans are now a lot riskier than when you had a lot more equity, and since they are more risky investments, the market is less interested in buying them than before and because of that they now have less value.
In comes your accounting team to tell you that, according to the law, you have to "Mark to Market" if you don't want to risk a serious penalty (such as jail time!) In their Mark to Market analysis, they estimate your value is now at $1 million; it has been reduced by 50%!
Don't forget, not a thing has changed regarding your borrowers or your loans (everyone continues to pay on time so the funds are still coming in just like it always has). Now however you now have to reflect the fact that the 'value' of Your Bank has been cut by 50% to only $1 million.
The thing is, you still have $30,000,000 of loans outstanding, and with a valuation of only $1 million, your capital ratio is now at at 30:1 and that is a LOT different than 15:1.
Red flags begin to go off all over the place because it's possible that with just a couple of loans that go bad that you would be required to cover, you might quickly run out of cash. This would put depositors at risk of losing their savings.
Now you have a situation where the FDIC is beginning to look into Your Bank and after that the SEC (Securities and Exchange Commission) is asking all sorts of questions. Your Bank stock begins to to fall hard. All the financial news networks catch wind of the story and just pour fuel on the fire.
Your Bank is in deep trouble.
The thing is, Your Bank is 'over leveraged', and to make up for that you are going to need to start selling some assets. (As an alternative, you could try raising some capital, but when you think about the way things look and your capital ratios totally out of whack, no one in their right mind is going to be willing to extend you the $1,000,000 you need).
Now, since you need to get that money ASAP, you find yourself in a similar situation to that of your neighbor who needed to 'dump' his home extremely quickly at a below-market price. As you sell as many assets as possible to raise capital quickly, at the same time you are minimizing the value (i.e. quantity) of your remaining assets, further skewing your capital ratios even further.
This is the kind of death spiral that is nearly impossible to stop once it gets started. The other issue is, the problem doesn't stop with just Your Bank.
Now let's say that my Portland mortgage company (le's call it "My Bank") bought those assets from you. You were unloading them at such a discount that My Bank got the feeling we were receiving such a excellent deal that we couldn't resist, so we bought tons of them.
The trouble is, with the Mark to Market regulations, the assets My Bank just purchased from Your Bank at such a good price must be used as comparables that all other financial institutions use to value their assets. So now each $200,000 Portland mortgage loan that My Bank holds (not limited to only the ones I just acquired from Your Bank) now only have a value of $150,000 each regardless of the fact that they were loans that were performing perfectly.
Now we have a situation where the value of My Bank goes down too. As this happens it negatively affects My Bank's capital ratios and forces me to need to sell assets as quickly as possible to be able to generate funds… and so the cycle goes on.
It is easy to see how quickly and wide-spread the problem becomes, regardless of the fact that there wasn't necessarily any 'bad business decisions' made. It's all due to a well intentioned, but over-reaching, accounting regulation.
If you think about the situation described above, you might ask yourself, "Why don't they have everyone just stop buying all the discounted assets from the other guy and just stop the cycle?" This is a very fair question.
When you stop the cycle, not only do some financial institutions go under, but the whole flow of money just stops in general. This is the 'credit freeze'. With no credit available, mortgage loan originations come to a crawl, car sales basically stop, people are laid off their jobs and the economy slips into a recession.
We've been in, and gotten out of recessions before. Why don't we do what we did the last time?
The minor recession of 2001 recovered pretty quickly because the Fed brought interest rates down and mortgage lending standards were a lot more relaxed, which ultimately led to nearly $3 trillion worth of cash being withdrawn in the form of home equity and injected into the economy.
In today's world, mortgage loan guidelines everywhere (not just the ones Portland mortgage brokers are dealing with) are considerably more restrictive, property values are way lower (and have been heading in the wrong direction for some time). And as mentioned above, the sad truth is that there is just not much money available out there for Portland mortgage companies to access for either home purchase loans or for a Portland mortgage refinance.
A bit of good news for a change!
4/2/2009 - The Financial Accounting Standards Board (FASB) voted favorably in regards to relaxing the Mark to Market standard. They are going to allow financial companies to use alternatives such as cash-flow analysis in valuing assets. This change is going to significantly reduce the write-downs banks have needed to take on assets and investments such as mortgages. This could potentially mean more funds will soon be available to your local Portland mortgage companies. We definitely hope so.
If you need more information about mortgages in general, or more specifically Portland home loans, you'll find some good
information and helpful tips at this website: Portland Refinance Help