Did you ever see the Stephen King movie The Happening, where people throughout New York City are committing suicide in mass? You see people literally turning on themselves to end their own lives as a result of some strange spore released into the air by plants protecting their existence. Well, if you think about it this is analogous to the current destruction underway in the financial system of the United States. Banks literally are turning the knife on themselves by sheepish lending practice while the accounting rule of mark to market is silently spreading to induce the massive death and destruction.
Mark to market is a rule whereby publicly traded companies must "mark," or declare, the value of their assets to what it would be worth if it was to be sold at that very moment. This rule, while widely used in valuing liquid assets such as securities was applied to nonliquid assets, such as real estate, after the Enron scandal. The general hypothesis towards applying the rule to nonliquid and liquid assets alike is to prevent companies from misleading investors by valuing its held assets at higher price than their "real" value.
The problem in the banking world is that banks are regulated stringently by the Federal Government and must maintain a certain ratio of assets to loans to be considered legally solvent. The result is that when a bank must mark its assets down according to the accounting rule, it is legally required to cover that write-down by adding another asset, usually cash, or decrease the number of loans it has outstanding. Since their is no practical way to call loans, banks must raise additional cash when the marketability of their assets fall regardless of whether those assets are performing perfectly.
Approximately 2.5-6% of home mortgages are in foreclosure. A staggering number, but not insurmountable. Now add that under 50% of Americans have a mortgage on their home. What do you come up with? Yes, you're right! The banking crisis has less to do with the foreclosures and more to do with arbitrary accounting rules. As infuriating as the truth is, the mark-to market accounting rule is forcing banks to value the homes that they hold mortgages on down to the values being received in foreclosure sales representing somewhere between 1.25%-3% of total homes! Even if one intends to pay every last payment of one's mortgage with the paycheck from one's stable Federal government job, and that mortgage payment is less than 25% of one's take home pay, the bank has to value that home as if foreclosing on it today.
The mark to market rule literally created the same bubble it is bursting. When the market was trending to the moon in 2002-2005, banks were allowed to mark the assets up to the market price. This increased the assets on their balance sheets and created more room for lending, thus pushing prices higher as more credit was made available. This sinful consequence flew in the face of sound accounting where gains on illiquid assets are not to be realized until sold. Subsequently, as prices began to fall, banks "marked" their assets lower limiting their ability to lend, which limited credit and prices fell further. Once prices fell further, the banks had curtail lending more and guess what?-Prices fell further. The sad reality is that the houses being sold determining this market value were not sold by choice, but rather as a result of foreclosure and therefore no true market existed. Further, with buyers unable to access credit because of banks having to hoard cash to make up for falling values on assets (95-97% of which were performing) fewer transactions occurred to stabilize prices.
Here is the rub, foreclosures had very little to do with the financial crisis, accounting and fear were the culprits, and I can prove it. If Bank A foreclosed on house 1 previously valued at $250,000, Bank A would not have to mark that asset down so long as they issued a new loan to the next Buyer at $250,000. Even if the next buyer couldn't afford the house and would subsequently go bad on the loan in one year, the asset value by rule would be $250,000. As a result, it was lenders unwillingness to lend that literally caused their inability to lend.
Clearly I understand that the moral hazard associated with the securitization of mortgages, relaxed standards by Freddie and Fannie and outright fraud caused much of the bubble of the housing market, but the illogical extension of marking illiquid assets to the market amplified the problem from a rising market to a bubble and then from a declining market to a catastrophe.
A great example of how the market rule amplifies itself occurred when Wamu was deemed insolvent by the FDIC and Chase Financial was given Federal assistance to take over the massive mortgage lender. In taking over Wamu, Chase marked all of the acquired mortgages down to what Chase and regulators deemed a palatable level. Regardless of whether or not the mortgages were performing, Chase marked them down as if they were to be sold that very day according to the accounting rule. Almost immediately following this transaction Wachovia was on the brink of insolvency as a result of how Chase had discounted the assets. All the experts agreed that there was no market for new homes and that the most difficult issue facing Wall St. and banks was how to put a value on them. Wachovia was profitable. Their loans were performing. Mark to market killed Wachovia because of how Chase valued the assets of Wamu in the forced sale.
Solution: An illiquid asset is worth whatever it is originated at and at its sale, disposition, trade or disposal a gain or loss is to be recorded. No matter what the system for valuing assets it will never be perfect, but surely it can be without unintended exaggeration. After all accounting is supposed to illustrate reality, not create it.
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