mark to market

There was an excellent question in the “comments” section that I wanted to bring out to the front page area. I responded to the question posed in the comments section, but for clarity wanted to put it in the main section of the blog, too.

From an anonymous poster:

“Care to discuss the issue of “Mark to Market” and its role in perhaps creating a great deal of the mess. I have read (which is always dangerous) that less than .5% of households are in foreclosure and something like 3% of mortgages are in default ( I admit I have not fact checked this with official organizations). I ask the question; given these low percentage how can it create such a train wreck? Transparency in financial institutions is always critical, particular as normal consumers (not multi millionaire who may be able to weather storms) as they allocate their limited resources. However, when transparency comes at the expense of the “last transaction” in a limited liquidity market (housing) where media likes to over excite things to evaluate billions of assets seems a bit silly. Could it be our overzealous search for Transparency and the “perfect market” contributed a great deal to the train wreck? Random ramblings and thoughts at this point. Care to comment?”

My response was as follows:

“Hey Anonymous Northlander,

Sure I would be happy to comment. First, let me make sure I understand your comment about “mark to market” accounting. You are saying that you think the huge decline in “paper” values of mortgages, as “mark to market” accounting necessitates, combined with a steroidal press-corp, led to a huge drying up of liquidity? Did I get that right?

In answer to that point: I think that “mark to market” accounting certainly contributed to some of the decline. The problem wasn’t with the adherence to the accounting standard, though. It was the fudging of the data that determines the value for Mortgage Backed Securities that caused such a stark decline. It’s my understanding that many institutions prolonged the reckoning/recognition of the true value of their MBS in hopes that the market would turn around. Once the market declined beyond a “range of reasonableness,” then institutions could no longer “fudge,” ne fake, the values of their portfolios. In other words, it wasn’t “mark to market” it was those damned liars who took advantage of the flexibility of “mark to market” accounting to overvalue their securities for so long that then consequently led to a dramatic and rapid loss of confidence in the financial system that is more to blame.

The best analogy that I can think of is imagining if your spouse had an opposite sex co-worker that they spent a lot of time with at work and out of work. If you began to suspect an affair and questioned your spouse about it, and your spouse said, “No, nothing is wrong.” So you stop doubting your spouse because you trust her/him and their convincing affirmation of the value of your marriage to them. Imagine the shock and horror then when your spouse asks for a divorce so that they can marry the co-worker? Your trust in them would decline almost immediately, and probably permanently.

I said above that I thought that “mark to market” was a portion of the problem, so indulge me a little and I will talk about something that I hope begins to address one of your excellent points. Namely, the size of the damage is seemingly very small, yet it is having a very outsized, disproportionate effect on markets, how can this be? Well remember that financial institutions are heavily leveraged. Your average commercial lending institution (i.e. a bank) is leveraged 10:1. That is, they are only required to have $1 dollar of deposits on hand to support $10 of loans (and other investments). So even a small write off in the value of their loan portfolio values requires a huge injection of cash in order to maintain proper liquidity ratios. Does this make sense?

Contributing to this problem was the fact that many of the bad practices were concentrated at individual institutions that cranked huge transaction volume through their doors (e.g. WaMu) so they had an outsize effect on markets. Does this all makes sense?

All of this said, I think that the response to the crisis has actually been about something else: a nagging feeling by many folks at upper and lower echelons of society that the ethics supporting capitalism have eroded so that the foundation does not support a rise, but instead, a collapse.

Great question! Keep ’em coming!
Anyone else out there, care to comment and contribute to our overall understanding?”

I wanted to add a bit more to this response that will hopefully lead to a greater understanding out there. In particular, I wanted to re-address the question of financial institution leverage. I had said that when banks have to write down the value of their “mortgage backed securities” assets, that they have to increase their reserves in the form of cash. However, what I neglected to mention was the rapid downward spiral that can result in this situation.

You see, what happens when a bank needs to raise cash in order to increase its reserves is that it either has to attract new and massive deposits from lots of new customers, which is highly unlikely to occur in the timeframe necessary, or the banking institution has to sell some of its other assets. Well if those other assets include “mortgage backed securities” then the prospective buyer is going to require that the MBS be valued using its preferred method. This conservatism on the part of the buyer is entirely understandable, isn’t it. After all, if a bank is in a cash shortfall due to having given loans to un-creditworthy folks, then isn’t it logical to assume that the MBS they are trying to sell now might also be garbage? Why yes it is! So when the stringent criteria are applied, the MBS that the bank is trying to sell is worth than it was on the books for, so less money is raised by the selling of this asset. And you guessed it…that triggers another need to shore up the reserves of the original bank, which then needs to sell more. And so on and so forth. Obviously this creates a vicious cycle of writedown-liquidate-writedown that is tough to escape.

I hope that helps lend a little bit of clarity to the situation.

Great question. Keep ’em coming!

Have a great weekend everyone.

Jason