What is left in the governments bag of tricks to get the banks back on track? One topic that I wrote about — 5 months ago — has popped up this past week with more and more frequency. We are finally starting to hear more and more chatter about relaxing “Mark to the market” regulations.
What is mark to the market?
Suppose a house on your street went into foreclosure. Previously, that home — and every other home on the street had a value of $600,000. But the foreclosed property went through a sheriff’s sale and was sold for $250,000. Does it mean every home on the street must suffer the same price cut? Events like this can “dent” prices up and down the street. But following market to the market regulations, every home on that street would now be worth $250,000.
Is that fair, or even realistic?
This is what banks and brokerage firms have been dealing with. It’s absolutely glorious when prices are moving up. But it is a nasty, vicious, life threatening downward spiral when prices are going down. Let me explain:
In summer of 2008, Merrill Lynch desperately wanted to get out of a large investment ($31 billion) of mortgage backed securities. Merrill, and many other brokerage firms were still carrying these bonds on their books at approximately $.80 on the dollar (80% of the face amount). They received an offer of $.22 on the dollar, only a fraction of what they were carrying them on their books. When Merrill completed the sale, all other similar investments — at Merrill Lynch and every other firm — had to be marked down to those kind of levels.
Here’s where bad news gets worse. Most banks and brokerage firms were choking on debt like this. After all, Standard & Poor’s and Moody’s had rated these mortgage backed securities as high-quality investments. This allowed banks and brokerage firms to hold these investments instead of treasury bonds (which had much lower interest rates), and these high credit ratings also gave them the opportunity to borrow against them. The benefit to the banks was easy to see. But everyone else benefited too: somewhat higher rates were paid on CD’s and bonds, loans were available to many, and mortgages were created at lower rates. We all drank from the well. Some more than others.
Here’s where worse news becomes a catastrophe. Many banks and brokerage firms were leveraged 30:1 or 40:1. Meaning, if the value of these bonds dropped by 5%, they had a serious problem. This is why they started creating, buying and selling these additional “bets” or “side contracts” known as credit default swaps. Most of these mortgage backed investments had already been marked down to about 80%. But the bar was brought down to 22 with that Merrill deal. Yikes.
I am completely against bailing out incompetent management. Wall Street and the banks have taken some really dumb risks and made terrible decisions. Indeed, some of these executives need to be shot. But the problem is that the banks provide “the grease” that keeps the economy moving. So something needs to be done. Mark to the market needs to be modified. Yes, it means changing the rules in the middle of the game, which really isn’t fair.
There’s more (much more), but that’s enough for now.