Polimom is not an economist. But if you’re having trouble understanding why there are liquidity problems in the banking world, you may as well start with the mark to market rule:
Let’s say Bank A and Bank B each own an asset, for which they each paid $100. For the sake of simplicity, assume it’s the only capital asset each bank has. Let’s further suppose that Bank A and Bank B are allowed to make loans at a ratio of 10 to 1 (in relationship to the capital). In this case, Bank A and Bank B have both therefore extended $1,000 in various loans.
But now Bank B decides to sell its asset for $110. Mark to market means that everybody holding the same kind of asset must now revalue to this latest price.
Cool! Bank B’s selling price means that Bank A’s capital goes up by 10% — which means they can extend a further $100 in loans.
But what happens when Bank B sells for less than what it paid? Say… $90? Now Bank A has to mark its own asset down to that same value. And because the regulations say that they cannot leverage further than 10:1, Bank A must also bring its loans back in line with the required ratio. So now they have to call in 10% of their loans.
So… now consider this: the recent “fire sales” (like Merrill Lynch) had assets selling for something like 22 cents on the dollar. Think about what impact mark to market will have on the asset values…. and thus the banks’ ability to make loans — or even leave existing loans in place.
Mark to Market for the non-economist (like Polimom)
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Made it! 🙂 Just to play devil’s advocate then, wouldn’t suspending the mark to market rule essentially artificially inflate values (by ignoring their decreases) such as to account our way out of the mess? My understanding is that the fundamental problem that has resulted in the current mess is that our levels of debt/leveraging are simply too high. If we artificially maintain asset values, it makes those values, well, artificial. There are no real assets supporting the debt.
Polimom,
This is a very nice, very simple example. Reality is. alas, much more complex.
Pacatrue asks an interesting question. Yes, leverage in the financial system is too high for today’s economic conditions. No, carrying an asset on the books at a higher value than it really has does nothing to accomplish the necessary deleveraging and may actually slow it down. However, artificially marking the asset down, based on an accounting rule induced “need” to mark illiquid assets to a market that has seized up and is going “no bid” much of the time, has the opposite effect. It exaggerates the (already serious) problem and accelerates the need to respond to it. There ARE real assets underlying the debt.
A residential mortgage backed security (RMBS) is much like a bond in the sense that it is a promise to return capital in the future and to provide monthly payments. Unlike a bond, it is a composite of many (say, 1,000) mortgages each of which contributes to the monthly payment stream and each of which contributes to repayment of the borrowed capital.
The problem is that some number of mortgages in the bundle will go bad and stop making monthly payments and will fail to return the original amount borrowed. The assumptions when the RBMS was assembled were for 99%+ of the mortgages staying good; today’s reality is much worse. However, it’s worth noting that even today, over 80% of the holders of sub-prime mortgages are current in their payments.
Even if all 20% of non-current mortgage holders immediately stopped paying their mortgages and the banks foreclosed on the houses and realized $0 recovery of the original mortgage amount in the foreclosure, the RBMS still has value. 80% of the original monthly payment stream is still there, and 80% of the original capital seems likely to be repaid. If both of these assumptions were sure things, the RMBS would be worth a little less than ~80% of it’s original value.
Mark to market, by requiring the RMBS to be marked down to the value the most recent desperate seller received, understates the value of all RMBSs, artificially lowers the bank’s capital, and thereby introduces artificial tightness in credit availability. And the more credit is withheld from creditworthy borrowers whose businesses depend on regular access to credit, the more businesses will fail, the more jobs will disappear, and the bigger economic disaster will result.
That’s a very high cost to bear in order to avoid reverting to the accounting rule that was in effect 12 months ago.
Hi Paca! The Master is correct, from my fragile understanding of this level of detail.
Because “x” percentage of the individual entities within these massive bundles are not stable, there’s a pretty common assumption that the whole kit and kaboodle is worthless. But as TM says — these “troubled” assets contain mostly solid mortgages, and they also generate an ongoing payment stream (via monthly mortgage payments).
Unfortunately, the very moment someone mentions “deleveraging”, my eyes glaze over. To my extremely non-economist eyes, it seems to me that the only way to get a real value on them would be to unbundle them and examine the internal contracts individually. But of course, we’re talking about millions of mortgages — an impossible task.
All of which leads me to conclude that mortgage backed securities should not be bundled and sold in this manner. There are entirely too many moving parts inside.