The Dynamics of the Financial Crisis: The Mark-To-Market Rule

People I’ve talked to recently are confused why we are having a financial crisis. The financial crisis is seen as abstract, with undefined dynamics, and no discernable impact on their daily lives. This article aims to explain what I believe is one of the drivers of the financial crisis, the mark-to-market rule, in a way an average homeowner can understand.

Disclaimer

I am not a financial analyst, nor do I have an economics degree. I do work with large financial institutions in my job and understand the dynamics of interdependent systems. Still, everything in this article may be wrong.

Furthermore, while this article addresses the mark-to-market rule, there are other drivers, like short-selling and the collateralization of securities, contributing to the crisis. I’ve tackled the mark-to-market rule because it’s easiest for me to explain in layman’s terms, and I believe it has a strong amplifying effect. However, I’m not proposing ditching the rule. There are too many accounting scandals possible without it. It’s just that we need to take into consideration its effects on the market.

It Starts With Credit

It’s called a credit crisis. But what is credit and how do we get it. Let’s go over the basics of credit.

Credit is where you borrow money from someone else with the promise that you will repay them in the future. You pay them a fee for the amount of time you’re using their money (eg: interest) and the effort it takes to loan you the money (eg: setup and management fees). Because there’s a chance you may not pay them back in the future, the person lending you the money asks you to commit to giving them something you own if you can’t pay them back in cash. This is called collateral.

The amount of credit someone is willing to give you is tied to the value of your collateral. Lenders make sure your collateral is worth at least the amount of money lent, so if you can’t to pay them back and they have to take your collateral and sell it, they can still get back most of their money.

Credit Is Tied To Equity

Collateral can come in many forms, but in the case of a home equity loan, your collateral is your house. Or more specifically, the equity in your house. So then, what is equity.

Equity is the amount of cash you would get if you sold your house and paid off your mortgage. The idea is that if you needed to repay your home equity loan, you could always sell your house, pay off your mortgage, and use the remainder to pay off your home equity loan.

To determine how much money to loan you, a lender determines what your equity is by estimating how much they think your house can be sold for, then subtracting your outstanding mortgage. The result is your equity, which determines the amount of money they will loan you.

Equity Rises And Falls

Equity is driven by two factors: your outstanding mortgage and the market value of your house. Your outstanding mortgage goes down over time, but the market value of your house can rise and fall. If the market value of your house goes up, your equity increases; if it goes down, your equity decreases.

A lender making you a loan estimates your equity at the time they make the loan. In financial terms, this is called “mark-to-market”, ie: they are marking the value of your equity based on value of your house in the housing market. In general, when you get a home equity loan, your loan is marked-to-market once, at the time the loan is made.

Now let’s assume instead that your loan was marked-to-market every month. Now your lender sees your home equity rise and fall every day. And when it falls, they get worried they won’t get paid back. So when your equity falls, they require you to pay back a portion of the loan immediately. So if in January they loan you $10,000 and in April your equity drops by half, they’ll call you May 1st and ask for $5,000 back.

The Downward Spiral

When your loan is marked-to-market once, you don’t care about the market value of your house after you get the loan. If the market goes down, you can just decide to live in the house longer and wait until thing improve. The housing market doesn’t affect you and you don’t affect the housing market.

When your loan is marked-to-market regularly, the dynamics change. Now at any point you may receive a call from your lender asking for money. And if you’ve already spent this money, you’ll need to borrow money from someone else, or sell something you own. If the market dropped only slightly, maybe you can sell your coin collection and be fine. But if the market drops dramatically, your only option may be to sell your house. And now comes the downward spiral.

A weak market exists because there are more people selling than buying. To attract buyers, people drop their prices. Those lower prices get used to mark-to-market the value of the houses not currently on the market. Which causes lenders to call the owners of those houses asking for money. Some of those owners decide the only way to pay the lenders is to sell their house. So they put their house up for sale. Which increases the number of people selling their house. So people lower their prices further. And the cycle continues…downward.

From The Brink of Collapse

You are now on the brink of financial collapse due to conditions beyond your control. A simple change in how often your home equity loan is valued has amplified market dynamics and forced you to the brink of bankruptcy. You need the market to stabilize so you can recover. What about a bail-out?

Suppose the market value of your house is now 30% of what you paid for it. Now the Federal government to comes in and promises to buy your house for 50% of what you paid for it. You’ll still lose money, but not as much. More importantly, you’ll stop dropping the price of house because at some point the government is going to pay you more than what you could get on the open market.

So people stop dropping their prices. Which means the value of houses not currently on the market stops dropping when they are marked-to-market. Which causes lenders to stop calling people for money. Which causes people to not have to sell their house to satisfy those lenders. Which reduces the number of houses being sold. Which relieves people from having to drop their prices.. Which stabilizes the market.

Back To The Financial Sector

How does this relate to the recent woes of the financial sector? Well, in this scenario, you are an investment bank, your house is equivalent to a mortgage-backed securities portfolio and the housing market is Wall Street. In 2007, a mark-to-market accounting rule went into effect which causes financial services companies to mark any mortgage-backed securities to the market at regular intervals, regardless of whether they actually sell them or not.

The result has been huge losses caused by a plummeting housing market. Since the value of these securities has dropped, the companies that lend the investment banks money are calling asking for their money back. And the investment banks have no choice but to sell like Merrill Lynch, or go into bankruptcy, like Lehman Brothers.

And Back To You

All this chaos on Wall Street should just stay on Wall Street, right? Well, almost.

The companies lending money to these investment banks, through loans and by purchasing their stock, are banks, insurance companies and pension funds, among others. If the investment banks go bankrupt or get sold at a fire sale prices, these banks, insurance companies and pension funds lose money. Banks, having less money to lend, will increase their rates and raise their standards for who to lend to. Insurance companies will raise their rates to compensate for money lost. And pension funds will have less money to pay out during retirement.

This means you’ll pay higher insurance costs, higher interest rates, and may not be able to borrow money when you need it. It also means your retirement, or your parent’s retirement, might not be as cozy. And these are just the immediate effects. Secondary effects and feedback loops, like the downward spiral described above, can drive the entire economy into a depression.

A Final Word

So what do we do? I addressed one way of how a bail-out plan would stabilize the markets. In principal, I think a bail-out plan would help. Without it, the downward spiral continues. Yet the devil is in the details. What is the price the government will buy these securities for? Will we have outside oversight? Can we limit CEO compensation or re-negotiate mortgage terms to give relief to distressed homeowners?

The right plan could be the best thing that happens to this country. It could stabilize the financial markets, prevent a broader economic crisis, and if the government buys these assets at the market price, when the markets recover in a couple years, the net result could be a huge profit. The wrong plan might still stabilize the markets and prevent a short-term downturn, but could lead us to a future of enormous debt at taxpayer cost, leading to long-term economic problems. Only time will tell which plan we get.

2 comments

  1. Lou says:

    Extensions to this concept I find interesting are…

    1) Closed systems in economics.
    Your job is what guarantees the loan payoff. But often both the loan value and your job are tied to the housing market. Also, your savings for a rainy day, are in the market which is impacted by housing value.
    So we have an unstable system, where a small drop in the housing market comes back on itself “doubly”.

    2) The stability of the system is dependent upon there being, and the market finding the “true” value of the product. The bailout defines (or should define) the “true” value in the face of the market failing to do so.

  2. Baron says:

    A simple amendment to the Mark to Market accounting rule would positively effect this crisis. It is exactly what the government is trying to sell to the voters. Why not let the Banks have the same opportunity as the feds? If the Banks did not have to write down their balance sheets in short term increments then they would not have to raise capital and could anticipate recapturing their equity on depressed assets at a latter date as conditions change.

    This would not only impact the Wall Street Banks but would filter down to the small S&L's who would not have to make calls on their customers, stopping the spiral.

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