Thursday, October 02, 2008

Why the Mark to Market Changes will help stabilize the national market

I thought I would share this article I found on Mark to Market and how it is driving much of the current crisis. The current mark to market rules were added to increase the accuracy of financial statements but have become a real problem that is somewhat artificially squeezing banks out of business because tehy are forced to value assets on their books at the last sale instead of the value based on their expected payouts. As in all things there is a grey area since there is room for the unscupulous to manipulate things to hide problems but I think that the appropriate balance can be found to reduce the current domino effect we are seeing and allow assets to be held at reasonable values until there is a more normal balance of buyers and sellers. That balance will be helped in great parts by having banks that don't need to sell something today at a fire sale price that goes on to trigger additional sales by other banks and so on I have been describing this situtation to partners and clients a lot recently so I was happy to see it in a well written informative piece.

I believe in having a deep understanding of both our local market and the national real estate and credit markets that come to play in the decisions my clients are making so if you would like to discuss what is going on in more depth or work with someone who has the depth to advise you thoughtfully feel free to give me a call on my cell phone anytime at 970-819-6930. I will listen to your goals and thoughts then give you an honest picture of the things you need to consider to make a great decision.

In Steamboat we are fortunate to have a much more stable market that has either maintained values or increased in most segments and has a whole since we don't have the two key things that drove the 80% of the problems located in 5 key states. They would be risky loans and tremendous over-supply. We are also fortunate to have well over 95% of buyers that do not need to sell and very little foreclosure activity.

The article: "There are a lot of rumors about what is happening in the financial markets. This should give you some insight on one of the factors. Whatever the political posturing regarding the current rescue plan, a plan needs to be passed. Credit markets are frozen and banks are going bust every day. This is not totally because of "toxic" mortgages. This has a lot to do with FAS 157, also known as "mark to market". This is only one piece, but is important to understand.

Each day lenders must mark their assets to the marketplace. The increase or decrease in the value of these assets is offset in capital. If values increase, capital increases, and if values decrease, capital is decreased. It's like you having to appraise your home everyday. If your neighbor was under duress because they got very ill, divorced, or lost their job and was forced to sell their home quickly they may have to sell it inexpensively. Let’s assume that with a normal sales process it was worth $500,000 and they sold it for $400,000. Now, does that mean your house is worth that $400,000? 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. (Think of the price you get at a pawn shop versus selling the item on an open market.) But "mark to market" does not allow for valuing at true market conditions, which creates a vicious cycle.

Why is this so bad? Most Financial Institutions are required to maintain certain amounts of capital relative to their assets (primarily loans and investments). As lenders mark down their assets thru capital, the ratio of capital to assets decreases with no change to the amount of assets they have on their balance sheet. For example, say a bank has $1 million in capital and they have $15 million in assets outstanding. Their ratio is an acceptable 15 to 1. But should they take a paper write down of $500,000 due to mark to market requirements, their ratio suddenly changes to 30 to 1. This is because their capital is now only $500,000 after taking the paper loss, while their loans outstanding are the same $15 million. And at 30 to 1 this bank is viewed as risky. 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 or investments to reduce its below “true” market prices. Yet really, nothing has changed at the bank. And this makes the vicious cycle continue.

This is not easy to understand for the general public. In fact most politicians don't get this either. That's why it is a difficult yet critical bill for them to vote on. Once this is done it will take some time but the markets will stabilize. As for the real estate and mortgage industries, it will take a bit of time but we will make it through this. Rates will remain attractive and the influx of credit availability will help the housing market gradually improve. This ultimately will be the medicine needed to improve the situation overall."
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