1. This site uses cookies. By continuing to use this site, you are agreeing to our use of cookies. Learn More.
  2. Discuss politics - join our community by registering for free here! HOP - the political discussion forum

Understanding 'Mark-to-Market' and it's roll in the economic crash

Discussion in 'U.S. Politics' started by Andy, Feb 7, 2009.

  1. Andy

    Andy Well-Known Member

    Joined:
    Jan 6, 2008
    Messages:
    3,497
    Likes Received:
    59
    Trophy Points:
    48
    Of course it's not exactly crashed yet, but it makes for a good title.
    This is a quick FYI about 'mark-to-market' what, who, how, and why it exist.

    General Accounting Practices
    For those who do not know, the federal government controls accounting standards through Securities and Exchange Commission (SEC), which requires publicly traded companies follow accounting practices put fourth by the Financial Accounting Standards Board (FASB).

    This can be found wiki on Generally Accepted Accounting Principles US page.

    In November of 2007, the FASB issued "FAS 157" a directive that required companies to value their assets using mark-to-market. But what is Mark-to-Market?

    Mark-To-Market (M2M)
    M2M is an accounting system that requires you value your current assets for the value they would have if they were sold in the market at this very moment. Hence, mark to the market. Examples tend to explain it better.

    Say you purchase a home in Palm Beach Florida for $175K. Now if you had to turn in a financial statement, you would have the asset of a house for $175K.

    However, if a hurricane was coming, what would the market for that home be? It would only sell for say $100K, because who is going to pay top market price for a house in the path of an approaching hurricane?

    Thus you would have to M2M that house for the $100K you could sell it for. On a financial statement, that would look like you lost $75K, even though after the storm passes, the house will still be worth $175K (assuming it survives).

    Similarly, say a company is building a automobile plant costing $600K, and the car market drops. Although the plant has the latest equipment, best tooling and most efficient setup, since the market for cars is depressed, the plant would not sell for very much. This would be recorded as a loss to the company, even if they didn't actually lose anything, and the plant will be worth $600K as soon as the market returns.

    Stock Market
    As soon as companies started marking down all their assets to M2M, their balance sheets all came up negative. The result has been a wide spread fall in profits... on paper. These posted losses drive down stock prices, resulting in the massive losses of the DOW and NASDAQ.

    These are called "unrealized losses" because they are not actually losing money. Most banks are not losing liquid cash from savings and checking accounts. It's all happening on paper. But how does a company end up going bankrupt from losses only on paper?

    Mortgages and Margin Call
    One way that unrealized losses caused by M2M, can reek havoc on a company is through Margin Call, in this case, on Mortgage backed securities. First, what is Margin call?

    Margin call is an agreement between a lender and borrower, on how much margin must be required in a loan. Say you want to buy stock in a company for $10. You find a lender that requires 20% margin. Thus you both agree to buy the stock for $10, you putting in $2, and the lender the other $8. The Margin is the value of the collateral minus the borrowed cash. $10 stock - $8 borrowed = $2 margin.

    Now say the stock drops in half. Now $5 - $8 = -$3. In order to get back to 20% margin, you the borrower, would have to pay the lender $4, or sell the stock to pay off the lender, even at a loss.

    In the banking world, say a bank sells a mortgage for $100K, and sells a Mortgage-back security to Fannie Mae or some other firm, for $80K.

    But then the "mark-to-market" rule for mortgage-back securities drops the assigned value of that mortgage to $50K. In order to keep the margin, the bank would have to pay their lender (Fannie Mae or whomever) $40K or sell the mortgage off to someone else.

    The result is, simply by having to M2M the Mortgage-back securities, the banks are forced to pay lenders thousands of dollars, or sell off their mortgages at a massive loss, that can drive them to bankruptcy... Even if they haven't lost a dime in real terms... just all on paper.

    The Vicious Cycle
    As long as home values, and home sales kept increasing, there wasn't a problem. But the instant that stopped, a cycle started that hasn't slowed yet.

    As soon as home values dropped, mortgage backed securities lost "market value". This forced banks to sell their mortgage securities to pay their lenders. Of course a sudden selling of mortgages securities caused their value to drop even more. Since their value was dropping, no one wanted to sell mortgages. With fewer banks offering mortgages, home sales declined. With home sales declining, homes lost value. With homes losing value, mortgages lost more value, because they had to be "Mark'ed to Market". And the cycle rolls on and on.

    The Source of the Problem
    So why the heck, after 50 years, did they make such a lousy awful rule? Answer: politics. In 2001, the Enron scandal broke. Headline after headline about how could this happen, and why wasn't it prevented, and how come Washington didn't do something, hit the mass media.

    Obviously the system worked in that it detected the problematic company, stopped the fraudulent activities, and charged those who committed crimes. Of course that wasn't good enough. We have to instead try and prevent it from ever happening again.

    The way in which Enron kept the massive losses of money from being detected, was by overstating the value of its assets.

    Say you were building, or rebuilding a classic car. A partially built car would be worth only a few hundred. But a completed pristine classic car, could be worth $25K or more. This is called historic-model, the prior system used for assets. You modeled how much the asset would be worth, based on historic values.

    Enron did this, except it overstated it's modeled value. Like claiming a classic car would be worth $10 Million when completed.

    So, the Securities and Exchange Commission putting pressure on the Financial Accounting Standards Board, and the result was FAS 157 which required Mark-To-Market... and here we are! :D
    (btw, a quick google of "FAS 157" turns of dozens of links from people predicting in mid 2007, exactly what happened a year later)

    Solutions?
    There's a couple. First, if nothing at all is done, the problem will iron itself out. How? Well obviously no one is going to be making any sub-prime loans, which are the main source of bad mortgages. As the more and more sub-prime loans are either repaid, or bought out, or foreclosed on, they will drain out of the system. Then things will equalize and we'll move on.

    Another way is for the housing market to pick up again. Obviously the population is still growing, and eventually the demand for housing will drive property values back up, making mortgage-backed securities pick up value. Again, this will equalize the market, and we'll move on.

    Finely, simply dump the "mark-to-market" rule, that was never needed before, and has only caused havoc since. Unfortunately, politics is more important to those in charge. The chairman of the SEC has said that despite the evidence and testimony from CEOs of corporations that have dealt with M2M, really the CEOs are all lying and just trying to cover up the fact their all horrible. (that's my paraphrase of his comments)

    My personal take is that the SEC will never revoke Mark-to-Market, because doing so will cause an instant rebound of the economy, and prove to most that government caused most of this mess. They'll never allow that to happen.

    (all information is based on what I understand at this time. If anyone has new or more accurate information, I'd love to hear it)
     
  2. Pidgey

    Pidgey Well-Known Member

    Joined:
    Jul 7, 2007
    Messages:
    1,125
    Likes Received:
    25
    Trophy Points:
    48
    Good writeup.
     
  3. Pidgey

    Pidgey Well-Known Member

    Joined:
    Jul 7, 2007
    Messages:
    1,125
    Likes Received:
    25
    Trophy Points:
    48
  4. Andy

    Andy Well-Known Member

    Joined:
    Jan 6, 2008
    Messages:
    3,497
    Likes Received:
    59
    Trophy Points:
    48
  5. Dr.Who

    Dr.Who Well-Known Member

    Joined:
    Jul 11, 2007
    Messages:
    6,776
    Likes Received:
    251
    Trophy Points:
    83
    Location:
    Horse Country
    Thanks for the summary.

    So another gov regulation does more harm than good. No surprise there!!
     
Loading...

Share This Page