This may be over a lot of people's heads, but I found this to be interesting as Congress is talking about this right now as we speak.

The 'Mark to Market' Accounting Rule:
What it is and why it is important to you now!

The financial crisis we are in today was not caused by mortgages or housing, although they were both catalysts. The real reason was an accounting rule called "Mark to Market" (also known as FASB 157).

Few people have a strong grasp of this rule, and even those who do have a tough time explaining it on air due to time restrictions. So let's take a few minutes to break it down.

Why does 'Mark to Market' exist? Let's go back to the stock market crash, which occurred between 2000 and 2002. With the S&P down 49% and the NASDAQ down 71%, many people lost much of their life savings and they were very angry.

Companies like Enron and Arthur Andersen were able to find ways to make their books look more attractive, which was reflected in an artificially inflated stock price. Both the public and Congress had a call for more transparency in business and hastened the passage of "Mark to Market" accounting. This is the notion that all assets should be valued as if they were sold on a daily basis. Under the letter of the law, failure to do this conservatively can now result in jail time. So what's the problem?
Before we get into what this means for banks, let me make a quick analogy using a scenario that should make perfect sense.

Let's imagine that you own a house in a neighborhood where all of the houses are priced at around $300,000. Unfortunately, your neighbor, who owns his home free and clear, falls ill and needs emergency cash quickly. Because he is under duress, he must sell the home for $200,000 in order to get the cash he needs right away, even though the home is worth considerably more. Now would this mean that your home is now worth the same $200,000 that your neighbor sold his for? Of course not, because you are not forced to sell under duress. It just means that your new neighbor got a great deal. However, if you were a publicly traded company and had to abide by Mark to Market account rules, you and the rest of your neighbors would now have to say, by law, that your home was worth only $200,000 - not the $300,000 you would get for it if you actually sold. So what's the big deal? Read on.

So how does this principle apply to banks?
Let's say we decide to start a bank . . . call it XYZ Bank. We raise $2 Million to open our doors. Remember that our capital account is $2 Million. Banks make money by taking in deposits and paying low rates of interest to those depositors (maybe throw in a toaster too). We then take that money and make loans with it at higher rates. We keep the difference.

So, we turn the $2 Million worth of deposits into $30 Million worth of loans. This puts our ratio of loans to capital (our Capital Ratio) at 15:1 ($15 Million in Loans to $1 Million in Capital). This level is acceptable, as long as we can shoulder some losses and recover. Because we are very conservative here at XYZ Bank, the loans we make require a minimum down payment of 30%, a credit score of 800 or better (that's nearly an 850 which is perfect), proof of income and assets, a reserve of at least two years of mortgage payments (normal is two months) and income requirements that only allow 10% of monthly income to cover all expenses (normal is 40%).

We do this and our loans perform perfectly. We make lots of money. Nobody is paying late and our clients are sending us holiday cards. They love us . . . it's a party. You and I are celebrating as we see our stock price soar. But real estate values decline and, even though all of our loans are paying perfectly, we must re-assess the loan portfolio to account for the decline in real estate values, which leaves us with less of an equity cushion. We had a minimum 30% down payment, which means the loans were 70% of the value of our assets - until we account for the decline in the market. Now, our position goes from 70% to 90%. That's riskier and, therefore, worth less than when our loans had a 70% safety position.

Our accountants tell us that we must "Mark to Market" or risk jail. They say our value is now reduced by $1 Million. Whoa! We must take or write down this loss against our capital account. It is a paper loss - we don't write a check, we have no late payers, no defaults, no bad business decisions. Still, we must reflect this $1 Million paper loss in our Capital Account, which drops from a $2 Million to $1 Million in value.

Here's where things get problematic. At this level, with $30 Million in loans outstanding, we now have a capital ratio of 30:1. At this level of leverage, alarms begin to sound. Our ratios are out of the safe zone; we could go under with just a few losses, deposits are in jeopardy. Hello FDIC examiner, we are on the watch list, the Securities and Exchange Commission (SEC) is asking questions and our stock starts to tumble. The business networks are showing negative coverage of our now troubled bank. We are in big trouble.

The problem, we are "over leveraged". The solution? We have to "de-lever" . . . and do so quickly. But there are only two ways to do that, and one of them isn't really an option. The first way is to raise capital, but that's not going to happen when our ratios are out of whack and we are in serious trouble as well as on the FDIC watch list. It is unlikely that anyone will be willing to invest cash in XYZ Bank.

The other option is that we can sell assets, like the outstanding loans, which are increasing our capital ratio. Like your neighbor, who owned his home outright but needed cash for medical bills, we are now under duress. The paper we are holding has a lot of value, but we have to sell it quickly and, because of that, cheaply. So, we offload the loans at a loss, which exacerbates the problem because those losses further reduce our capital account.

Very quickly, like a flushing toilet, things start to spiral - we are going down.

Cont'd

The problem doesn't stop there. The fire sale we just had on our loans makes things worse - even for the banks that bought them up and thought they were getting a great deal.

Under Mark to Market, the loans we just sold must be included in the comparables that other financial institutions use to value their assets. This is how the problem spread and got so bad so fast. Other good institutions, with good loans, have to mark down. Just like us, they become over-leveraged. It's a chain reaction, all triggered by a well intentioned, but over-reaching accounting rule.

Financial institutions fold, sell, or freeze. Credit - the life blood of our economy - is cut off at the source. Because of a lack of available credit, home sales and refinances crawl, auto sales drop and jobs are lost. Additionally, the economy enters a recession.

During the last recession in 2001, the economy recovered relatively quickly thanks to $3 Trillion worth of home equity withdrawals. But, more restrictive programs, a lack of available credit, and lower home values will make it difficult for us to use home equity to help pull us out of a recession this time around.

The Federal Reserve has passed a rescue plan, which, over time, will provide some level of help. Some banks will get money to infuse into their capital accounts. Others can sell some assets to the government in an effort to "de-lever".

But, the big thing that is not talked about, not well understood, is the part of the rescue plan that traces this financial crisis back to the source.

The US Congress has given the SEC its blessing to modify "Mark to Market" accounting. It won't be eliminated, as we will not want to go back to the Enron days. But the SEC is likely to adjust the Mark to Market provisions.

Here's one potential solution - even rental or commercial real estate properties can be valued two ways:

1. The comparable sales method, which determines the value based on what other assets have sold for, which is the way Mark to Market work currently.

2. A cash flow method, which values the property based upon cash coming in.

If we see Mark to Market modified to use cash flow to value assets, without requiring a large percentage discounting mechanism - wow! What a shot in the arm that would be. We'd likely see the stock market rally, with financial stocks leading the uphill charge.

Consider that, in today's market, fund managers are holding 27% of their assets in cash, compared with just 3% they held in cash when the stock market peaked in October of 2007. That means there is a lot of money on the sidelines that can push stock prices higher. Additionally, think about the redemptions from hedge funds that eventually need to be put back to work. That's another reason to be optimistic about stocks in the first quarter of 2009 - provided that Chairman Cox modifies Mark to Market accounting in a meaningful way. And a good stock market helps individuals feel better about purchasing homes. Additionally, stronger balance sheets for financial institutions will allow them to lend more money.

"This may be over a lot of people's heads"

There are few accountants in Congress, and that is a problem. Never mind that it's "over the heads" of many non-accountants on the forum, it's beyond most members of Congress. The difference is most of us will read and comprehend some of it and probably understand the key messages ... bookkeeping gimmickry doesn't change the raw facts and "more restrictive programs, a lack of available credit, and lower home values will make it difficult for us to use home equity to help pull us out of a recession this time around."

You don't need to understand big picture accounting details to understand what Mr. Letterman keeps saying in his monologue every night, "Who's got all the money?" Bernie Madoff made off with most of it and he's going to jail without singing. The Bush team gave a good chunk of it to Halliburton whom spun off KBR whom gave it away to contractors of an unknown origin.

The details of SEC accounting procedures are pretty much lost on everyday folks. It's like explaining why radio frequency energy is governed by Maxwell's equations to a bunch of DJ's. They couldn't care less. Just broadcast me. Well, when it comes to accounting practice on the mega level, just fix it so I there is work to be done and I can restore my long lost cash flow.

Vitalogy...I really appreciate your work on this.

The question for me is this: Is Obama's plan going to be effective enough to stabilize the market so we can begin to see banks doing what banks were doing before my neighbor got sick and undersold his property?

Chris, this isn't Obama's plan. Obama has no plan other than to raise taxes and to destroy America as we know it. This is Congress as indicated in the first sentence of the thread.

Oh crap, there I go again being critical of the Messiah.

I would try and engage you, Deane - but I just bought a hammock.

No I don't care to get in it with you.

Bush and the GOP already destroyed America. Obama is trying to fix it.

The housing plan will help, but it's not a silver bullet. It will not help investors, flippers, people who did stated income loans, and many others who bought homes they could never afford no matter what is modified on the mortgage. So, housing prices have nowhere to go but further down, especially the upper end homes which I would describe as the $500K-$800K market here in Portland. At some point things will bottom out, but not this year, as homes have to fall to a price where people can afford them and can obtain a loan on it. If you need to borrower more than $417,000 to buy a home, good luck getting a loan, and if you do, close you're eyes when you see the rate you'll pay.

I'm not an accountant, but I do understand the issue of a bank's capital ratio and how important it is. If making reasonable changes to the accounting rules will help banks weather the storm, more credit will flow to borrowers who need it, because when banks have to protect their captital ratio, the first way to do that is to quit lending money and keep it in the vault. As more credit flows to people and business, it will allow the economy to start growing again.

Another interesting article:

http://money.cnn.com/2009/03/12/news/fair.value.hearing.fortune/index.htm?postve rsion=2009031212

Deane it's unfortunate that you can't see the destruction Bush and his crew did. You're like a kid who messes up the living room and expects everyone else to clean up the mess. Your attitude is " what's your problem."

Just keep adjusting your blinders Deane, that's about all you got these days.

Oh yeah-the 8 year plan from Bush has me stitches.

"Deane it's unfortunate that you can't see the destruction Bush and his crew did."

I see plenty of destruction that Bush did. I just don't happen to think it benefits us to have Obama do even more destruction and destroy America as we've known it for over 200 years.

And we factor out the New Deal time, in that 200 years?

Say what?

I just don't happen to think it benefits us to have Obama do even more destruction and destroy America as we've known it for over 200 years.

DUHbya and Co. has done more damage to America than Obama could EVER do. 200 years? If that's true about Obama then DUHbya and Co. destroyed America FOREVER!

There goes the neighborhood. I'm signing off.

The neighborhood went in 2002 Deane sorry to say....
BUH BYE!

Good posts Vitalogy. Thanks!

Deane, my point was that America has not been constant enough to make your statement "destroying the America we've known for 200 years" supportable.

That's long hand for "whining".

Okay Deane you may have signed off but you might lurk.

I would be interested in what you have as an option to what has been proposed. I mean I want details and why they would work. And what I don't want is " I don't really have a plan but what's in front of us isn't going to work" BS.

You're an intelligent guy Deane, you must have some ideas that you can line up with and explain to a dimwit like me. I truly want to know what it's going to take to turn things around. No dancing around the question, no BS. Give it to me straight or shut up.

Chris Taylor: "Vitalogy...I really appreciate your work on this."

The author of the original piece Vit quoted; Barry Habib, Chairman of the Board, Mortgage Success Source.

I'm signing off.

That's one station that needs to have its license yanked permanently.

Magic-Your point?

" Who deserves the credit " is a game around here that is played WAY too often for me. " Who deserves the blame " of course, is the only other game sometimes. I'm not immune to invoking phrases that smack of it either. But I do find it tiring.

Let's try a new game.

Who's got the best idea? Everyone has to play. Take it as serious or as ridiculous as you like. The only rule is that you cannot, in your opening statement to the jury ( me - because I thought of it and deserve the credit ) is that you can't tell us what you would NOT do.

First topic;

Hmmmm. Something important to everyone. Not just some pet project or obsession. I want to try and think of one that is relevant to many of us here. Hmmm.

OH OH - I GOT IT! ( And the sheer irony of discussing it here is poetic );

RADIO!

Here is the puzzle to solve;

In your view, what are the problems that radio faces and what are some of your solutions?

The winner, as chosen by me, gets to pick the next topic and present the opening debatable question.

And as per usual, when I try and have some fun with you critical thinkers and then you just don't want to play with me...I will blame someone. TBD.

"Magic-Your point?"

My point was that when one copies and pastes an entire copyrighted article, as Vit did, the actual author should receive the credit.

Seems a more economical use of Dan's bandwidth would be to simply post a synopsis and a link to the original piece. IMHO.

From today's New York Times Business Section:

http://www.nytimes.com/2009/03/13/business/economy/13norris.html?_r=1&ref=busine ss

The article was emailed to me without a source. I don't really give a crap who the source is, and if you think that I made that up myself and intended to take credit for it, you're an idiot.

And if you're worried about Dan's bandwidth, I'd suggest editing your own posts as well or doing none at all.

Yes, Sir!

http://money.cnn.com/2009/04/02/news/fair.value.fortune/index.htm?postversion=20 09040212

NEW YORK (Fortune) -- Rules makers adopted guidelines Thursday that give financial firms more latitude in applying so-called mark-to-market accounting, just in time for what is shaping up as another tough earnings season.

The Financial Accounting Standards Board, the private sector body that sets U.S. bookkeeping rules, moved Thursday to adopt a rule that makes clear that firms need not write down the value of their assets based on so-called distressed sales of similar assets by other banks.

Stock market is up 250 points on the news!

Here is a Mark to Market scenario for you.

I live in a manufactured home park, a nice one in Kennewick about 175 houses. I have lived here for 22 years. Down the street is a rather nice 94 Marlette double wide about 1500 sq ft, lived a guy about my age with 2 kids living at home, kids are in their 20s, both boys. They got busted big time for selling Methamphetamines and Pot out of the house .

The corporation that owns this Park and of course the local manager told the old guy, the owner, all of you get out now, or we will evict you and we can with the help of the district atty based upon your leases and the pending convictions as they raided the place during a sale that was set up in a sting operation. They moved out. He put his place up for sale for 10 grand ! We dont own the lots here, just the dwelling on the lot. We have leases for the lot and pay lot rent every month.

My place is an 87' about 1100 feet, so its smaller than the drug house, a bit older, but the real worth of my dwelling is or was about 24,000 $, even in the depressed market lately. So now, this guy is desperate to sell his shack for 10 grand, and even in the depressed markets , he will sell that place anyhow. ( No they werent making the Meth in the house, just selling product, so the house isnt tainted ).

Now, as long as its your house standing on the land, it is your responsibility to continue to pay the lease payment and if it is still there when your lease is up you are forced to sign a new lease for another year ! So you have a double whammy here if you are the drug lord guy.

Meanwhile the rest of us are getting screwed by a defacto Mark to Market conunndrum here.

The 'Mark to Market' Accounting Rule:

Seems less confusing than the 'Earth to Boosh' Accounting Rule:

The reality is nothing has a VALUE until an agreed upon price is reached. I have a silver dollar. A price guide says it's worth 7500.00. The govenment says it will buy one dollar worth of goods and services. The local bank will give me one paper dollar for it, 1 800 Cash for your old gold and silver will give me 13.00 for it. MAYBE a collector offers me a price close to the book value. Until the exchange is made I have to carry it on my books as Value ONE DOLLAR.

As described in KMANS scenario value is based on varying factors.

PS, if you buy a home, get the land too. this land lease business is a greedy scam! Why would anyone buy one of those Marysville homes on Indian land? You cough up 80K for the house title, but pay "RENT" of 800 a month. Let the Indians live in them.

The Newshour with Jim Lehrer had a piece on this yesterday (April 2nd).

Getting back on the original topic, I personally just started an "Intro to Accounting" class. Right away, it's clear how numbers and figures can be jerrymandered to make everything appear to look just fine, when in reality they aren't.

IMO, the accounting practices of most businesses, as well as the Federal Government are jerrymandered and unrealistic.

My simple mind says you take in a certain amount of money, you spend a certain amount of money and you have a certain amount of money left over called profit. Anything deeper than that is playing with numbers.

The example of Mark to Market theory posted by Kennewickman above is excellent. Using his example, where should the fair market value of other properties in the park be pegged, on the distress sale, on anticipated fair market value, or perhaps on replacement value?

KW kinda missed the point. Here's a better analogy:

You buy your home for $100,000, put $20,000 down, and your lender signs an agreement with you that your loan is good as long as the loan to value is 80% or less. Your neighbor sells his home which is similar to yours for $90,000. When your lender finds out about this, you are now in violation of your loan agreement in regards to the loan to value. You're now at 88%. The lender tells you that you must liquidate your retirement or savings to get back below that 80% loan to value threshold. The fact that you now have to liquidate $8000 to be in compliance with the agreement you and your lender agreed to causes distress. Things compound from there.

Thom Hartmann keeps saying that because of Mark to Market we will get another bubble and another burst. He had Ravi Batra on the other day for over an hour taking about the true fundamental flaw that is crippling our economy. Price of goods have gone up and the price of wages have not kept up and no amount of credit can make up the difference. just my 2 cents but I agree.

Deane, my simple mind works that way too.

There is an awful lot of funny money floating around

Moman, I agree too! We need to build stuff. Any stuff, and consume it here, and lock in a few markets here.

I am worried that "free market" ideas remain strong. Many nations are anti protectionist. Truth is, they are that way because they don't have production to secure their place in the global economy.

The work to fix that is tough, but would be better for everybody.

I'm still sorting out what Mark to Market really means. I'm even more troubled by the fact that most solutions do preserve the big financials interests more than ours. Losses are being socialized to a greater degree than I think is healthy or warranted.

BTW: I think replacement value has a lot of merit.

Vitalogy, at that point I would tell the lender the following: I have and continue to make all of my payments on time, my net worth and income are unchanged. Either you leave my loan alone, just as it is, or I stop making payments and you can do whatever you want. How much trouble do you want to buy?

I have no use for bankers/financial people. I think they are among the stupidest people in the country.

Seriously.

I would do the same thing. If the arrangement is performing, they have absolutely no reason to go down that road.

I used the lender situation as an analogy to help you understand. Of course that would never happen as long as you're making the payments on time.

The issue with the banks is that they have to maintain certain capital levels to be in compliance with what the government allows. When banks are forced to write down their assets, it fucks up the capital ratio. Simple as that. So in order to prop up the capital ratio, they raise capital or sell assets. And since it's hard to raise capital when no one has confidence in your entity, the result is a fire sale of assets which furthers the downward spiral since everyone else has to write their stuff down too thanks for your fire sale.