Per the request of a friend, this short essay.
We'll begin with something Charlie highlighted from the WaPo.
Simply put, mark-to-market accounting requires companies to set the value for the assets they own at the price they could fetch on the open market right now. The prices must be "marked to market;" hence the phrase.
What does that have to do with the current crisis? The root problem now is that financial institutions have been caught holding value-less, or "toxic," assets on their books, such as the mortgage-backed securities based on sub-prime mortgages that have defaulted. [See below]
The government believes that those assets will be worth something soon -- that's why they want to buy them in the $700 billion Wall Street rescue plan. But under mark-to-market rules currently required, they are worth almost nothing, threatening those who hold them with insolvency.
If the holders could place a value on the assets equal to the estimated value they should bring in the future, suddenly the balance sheets of these financial institutions would look a lot healthier.
Now to back up a bit.
Banks lend money based on a couple of factors: 1) their deposits, and 2) their capital. The smaller the deposit base, the less a Bank can lend. The smaller the Bank's capital, the less it can lend. (There's a lot of arcane stuff buried in the above, but that's the simplified take.)
Banks earn money in three ways: 1) interest on loans; 2) interest on other investments; and 3) fees. We're interested in #1 and #2 here.
When a bank makes a loan, the loan is booked as an "asset." So long as the borrower pays up on the terms of the agreement, everything's hunky-dory. But when a borrower misses a few payments, that loan becomes 'troubled.' Maybe the trouble is temporary--the borrower was sick, but will make up the difference when he's earning money again. Maybe the borrower is actually defaulting--that is, simply not going to pay off the loan at all. In either case, the bank examiners, (Federal Reserve, FDIC, and/or State) note the loan's non-performance and require the Bank to set aside a "reserve" to offset the potential loss. That "reserve" is a charge against earnings. The bank is forced to take the loan out of the "asset" category and, if there are enough of those 'bad loans,' the bank eventually is LOSING money, not making it. That loss is made up for by the bank's "capital" account (shareholder equity.)
Not good. When the bank's capital shrinks, the bank cannot make as many loans--so they have to "call" some loans which are good, forcing other borrowers to pay up--NOW.
Banks also have "other investments." These are (commonly) US Treasury bills, Fan/Fred preferred stocks, and maybe a few "mortgage-backed-securities" which promise higher interest or divident returns than standard commercial loans.
The mortgage-backed-securities have become a problem. That's because nobody actually knows what is in that bundle of debt. Nobody really knows how many of those mortgages will be paid, or not paid.
Enter the accountants and the SEC. Above we highlighted "RIGHT NOW" in the WaPo article. Under "mark-to-market" rules of the SEC and the accountants, the MBS's the banks hold may have to be written down to zero value--because nobody knows with certainty what they are actually worth if you sell them right now.
When those are marked down (to "market") the bank is forced to take a charge against its equity (or its earnings.) Either way, that reduces the bank's ability to lend money, whether right away, or in the future.
When banks are forced to stop lending, nasty stuff happens. Most businesses borrow money regularly for cash-flow purposes (kinda like using MasterCard; you'll get a paycheck in two weeks, but the car's radiator has to be replaced now.) They also borrow for new equipment--usually on a 3- or 5-year payment basis.
Now imagine that the business goes to the bank and asks for $100K to make payroll, knowing that their best customer will pay them $250K for the goods shipped--but not for 10 days.
If the bank has been hit with "market" rules and a few questionable loans, the bank may have to tell the businessman to take a hike. "No money for you. Sorry. So sad, too bad."
Ugh. What about payroll? What about paying vendors? What about that new machine we can use to reduce costs (or just to make our product)?
"So sorry. Too bad."
What Paulson proposed was to have the Gummint buy up all the MBS's. When that happens, the Banks no longer have "impaired" assets, meaning that their equity and deposits can once again support lending. Paulson figures that although the MBS (and CDO) packages have some bad loans, they are not ALL bad loans--and even if the bad loans fail to default, the Gummint still has the house/land to sell.
It's possible that yesterday's change in "mark-to-market" rules will stop some of the bleeding immediately and pull many banks back into 'the black.' It's possible that that change alone will be sufficient. We don't know, yet.
People who watch the Dow aren't watching the right stuff. What counts to the banks is what they have to pay for their funds. That means "LIBOR," which is the interest rate paid by banks for overnight (or longer) loans from OTHER banks.
When the bailout failed to pass, LIBOR overnight rates hit an all-time high.
Like paying a lot for your car-loan? You'll be in hog heaven--if you can GET a car-loan. And the same applies to businesses---their interest rate will go up, too (the bank ain't a charity.) When interest payments go up, something else has to go down....payroll?
As Ryan said: it's awful, but it's what we may have to do.
Nobody said the Constitution is a mutual-suicide pact.
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