The "Mark to Market"Rule: The Root of the Collapse of Our Economy

So let’s say that you wanted to borrow some money to remodel your house. You visit your formerly local bank and list your assets on the application form. You estimate your house to be worth $250,000.00, and you are carrying a $100,000.00 mortgage. You therefore conclude that the net worth of your house is $150,000.00, and you proudly put that figure into your application.

Upon reviewing your loan application, the loan officer advises you that your asset list is wrong. You can only value your house for what you can sell it for today. And he means “today”. What can you sell your house for today? I suspect it would be “0”. In addition, because you have a $100,000.00 mortgage on your house, that means your house is actually worth $-100,000.00. You loan request is politely declined.

That, my friends, is the “mark to market” rule. Banks are only allowed to value assets for accounting purposes based on what they could sell them for today. It is this rule that has caused a complete collapse of our financial system, and is perpetuating the crisis in our economy.

“Mark to market” is a system of accounting developed in the 19th century by commodity future traders in order to protect themselves against too much borrowing. Trading commodities on margin (with borrowed money) put the institutions at risk. Traders were therefore required to value the traded commodities based on the closing market price of the commodity at the end of each day. If the price went down too low, then margins were called, and assets had to be sold in order to bring margin amounts into the allowable standards. Buying and selling stocks on margin works the same way today. It works very well on assets that are continually traded on a daily basis allowing for readily determined price.

It began to move into the banking system in the 1980’s, and kicked into high gear in the 1990’s. It worked for some things, but for the most part was problematic in dealing with assets that were not traded daily; real estate, for example. As the banks started packaging mortgages into bonds for re-sale based on the value of an underlying real property asset, it was hard to put a value on the bonds because the underlying assets, housing, did not fit the “mark to market” model of daily trading.

So, they devised a system to value the bonds called “mark to model”. Through use of computer formulas, the handlers valued these collateralized debt instruments (CDI’s) based on a projected model, using certain assumptions as to the “value” of the underlying real estate asset which may or may not have been legitimate. For example, the value of real estate will always go up. As with all things computer, putting junk into the model yielded junk out. The entire system was prone to fraud by use of erroneous models, deliberate or otherwise.

Then came the Enron scandals, which were filled with these types of model-based securities. Many, if not most, were fraudulent. The government and its supervisory entity, The Financial Accounting Standards Board, attacked the perceived problem with a vengeance. In its Fair Values Measurement Statement, it required all entities to use a “mark to market” type model for all valuations of assets beginning in November of 2007.

The basic problem of valuing mortgage backed bonds still remained. Housing values could not be readily determined on any kind of a daily basis. When the economy started a slow down based on a spike in energy prices, and foreclosures rose slightly, investors eyed these mortgage backed instruments with some skepticism, and the values of the bonds started to fall. Because of the accounting rules, banks started to have to discount the bonds on their books to what they could sell them for “today,” even if they weren’t for sale, even if the bank intended to hold them to maturity, even if 99.0% of the bonds were performing. Mortgage foreclosures went up 2/10th of a percent, and the mortgage backed bonds fell 30% in value.

It began to feed on itself. Because these write downs directly affected the capitalization of the banks, and the banks needed to maintain a certain level of capitalization to meet FDIC requirements, the banks tightened lending standards, and stopped lending money. Not only did the banks stop lending money, the “mark to market” rule affected just about every entity that held any of these “worthless” bonds. That included brokers, insurance companies, any finance company, your 401k’s, hedge funds, mutual funds, anywhere these bonds might show up. They may be performing 100%, but must be valued at “0”.

The economic death spiral began. Even when 98% of all mortgages were performing, banks were forced to mark the associated bonds down to nothing causing massive capitalization losses. Banks went out of business. This caused even less lending. The value of houses started to plummet. People now could not renegotiate their mortgages because the houses couldn’t meet the new stringent equity requirements, and foreclosures increased geometrically. This caused even more defaults as the malaise spread into the economy into the home builders, into the manufacturers. Banks started laying off massive amounts of employees. So did all financial institutions as they were deemed “bankrupt” by these so called “worthless” bonds.

It culminated in September with the Lehman Brothers bankruptcy. Credit markets completely froze as interbank lending, the lifeblood of our financial system, totally stopped out fear of who held what bonds. An analogy would be the banking system having a heart attack.

Government officials panicked, and recommended a bailout package that would allow the government to purchase these valuable, but valueless, bonds from the financial institutions to stabilize their balance sheets. In other words, catheterize the clog. But after Congress passed the legislation, the government changed its mind, and left the bonds on the books of the banks, and instead gave the financial institutions “cash infusions” to boost their capital, which in turn was eaten up by the banks having to further write down the bonds as the self-feeding recession picked up speed.

When Secretary Paulson announced this new approach, the stock market tumbled. Why? The government couldn’t figure out how to value these bonds. By deciding not to provide a mechanism to buy them, it made the bonds even less marketable. These bonds, worth nothing in a “mark to market” environment, were now even worth less, and the banks are currently stuck with continually writing these assets down as these bonds become more toxic as foreclosures increase, and the economy tanks. It is becoming a self perpetuating fiasco, growing geometrically.

Instead of a viable solution, the government has chosen to selectively loan money to the financial institutions to bolster their balance sheets. But until the value of the underlying real estate stops falling, it is like spitting in the wind, and the taxpayers are now facing a black hole across the board as the malaise spreads throughout our economy like a cancer. It has made what should have been a mild blip in our economy into a serious problem, with major corporations collapsing, millions of jobs at risk, the government now an equity holder in major corporations (do you really think that is a good idea?), and the taxpayers on the hook for trillions of dollars.

To put it into perspective, you have seen a major, cataclysmic realignment of the American financial system in 10 weeks. It is breathtaking in its scope, all from a badly thought out accounting rule.

If you think I am blowing smoke in the wind, one of reasons GM, Ford, and Chrysler are in front of Congress, hat in hand looking for handouts, is there is no money to loan to buy cars.

That little accounting rule has destroyed our economy. Everyone agrees that the bonds in question are worth something. It is absolutely inconceivable to me that these geniuses cannot devise a standard formula as to how to put a value on these bonds, and give our financial institutions a chance to establish financial statements based on realistic assessments and assumptions. In this case, the cure to the Enron problem has proved to be fatal.

Until the government addresses the primary cause of our problems, the economy will remain stagnant, and we are in for some hard times. Until a system is devised that will allow a realistic valuation for the bonds, and allow for the free flow of these instruments within our financial system, the most we can hope for is some stabilization. Housing and our economy will remain stymied. And we will be saddled with trillions of dollars of debt which will cripple us for years to come.