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.