What the heck is mark to market?

It is the beginning of October, the credit markets are frozen and banks are going bust every day. This has a lot to do with FASB 157, also known as "mark to market".  Each day, lenders must mark their assets to the marketplace. It's like you having to appraise your home everyday and, if your neighbor was under duress because she got very ill, divorced, lost her job and was forced to sell her home quickly, she may have sold it super cheap. Now, does that mean your house is worth that super cheap price, too? Clearly not. Why? Because you are not under duress. You have the time to sell your home and get a more normal price, which more accurately reflects true market conditions. 

But "mark to market" does not allow for this, which creates a vicious cycle.  Why is this so bad? Because as lenders mark down their assets, the amount that they have previously loaned becomes much riskier in relation to their assets. For example, say a bank has $1 million in assets and say they have $15 million in loans outstanding. Their ratio is an acceptable 15 to 1. But should they take a paper write down of $500 thousand due to "mark to market" requirements, their ratio suddenly changes to 30 to 1. This is because their assets are now only $500 thousand after taking the paper loss, while their loans outstanding are still $15 million. And at 30 to 1 this bank is viewed as a risky investment. So the stock price starts to get hit, it becomes harder to borrow, and most importantly harder to make money. The bank is then forced to sell some of its loans to reduce its ratio...at cheap prices. And this makes the vicious cycle continue. A quick look at the holdings of these loans show that 95% are problem free.  Now add to all this, the opportunistic "shorting" done on the financial stocks (much of it illegal because those shorts did not legitimately borrow shares) and you exacerbate this whole problem. 

Another issue being widely discussed is the take over of Fannie Mae and Freddie Mac.  Many people feel like the government should not have stepped in and taken over these companies, but rather let them experience whatever the free markets had in store for them.  Letting that happen would have crippled the real estate markets even in areas like DFW.  Rates would have shot up to around 10% and real estate transactions would have come to a standstill.  What we need to remember is the people making the financial decisions for our country like Ben Bernanke are brilliant. The biggest fear circulating around Fannie and Freddie is that they would become short on capital and not be able to pay their investors on notes coming due.  

 

Well, how do Fannie and Freddie raise capital and ease investor concerns? By selling new notes of course. So, by the government simply stating that they are going to back Fannie and Freddie bonds, they solved their liquidity problems.  Like I said, brilliant.