Vail Valley: Can some good come of the economic crisis?
Vail, CO, Colorado
It’s often been said that some good comes from everything. My mother was an English teacher and always pushed her students and children to respect the power of words. That is probably why I am fairly good at writing columns such as this one.
So if there is one thing that might please my mom about the current economic crisis, it is that people in the Vail Valley and elsewhere are learning a lot of new words. I can assure you she is not pleased about the other impacts.
A year ago, I doubt many people even had heard of words or terms such as “mark-to-market,” “loan modification” or “cram down.” Indeed, these are words and phrases of our time, and to understand a bit more of what’s going on in the world, it’s important to understand these three.
In the next few columns, I will discuss all of these and the implications they hold for every consumer, but today, let’s look at what “mark-to-market” means for all of us and what many economists really consider to be the root of our current problems.
If there is one thing that led to the current crisis, it was a change in accounting principles that surfaced about two years ago called mark-to-market. On the surface, it sounds simple enough ” it requires financial institutions to carry assets such as loan portfolios on their balance sheets at what the market value might be if they had sell them in a reasonable time. In other words, peg the value of an asset at its market value.
The problem is that these assets are usually structured to be put on the shelf of a bank vault and forgotten about for many years. The market value may ebb and flow, but the intrinsic value in a portfolio of mortgage loans is a long-term, predictable stream of income. As such, institutions had for decades been allowed to factor in a long-term value when stating the value of these on their balance sheets. This provided a buffer of sorts to the worth of the company as other assets and income streams fluctuated.
The timing of the change in accounting rules coincided with the rising default rate on sub-prime mortgages. I remember the day I heard about this change and had a sense of foreboding that this was not a good thing.
The collision of a seemingly innocuous accounting-rule change and the start of higher-than-expected defaults on sub-prime loans caused the trading in mortgage-loan portfolios and their underlying mortgage-backed securities and many other complex debt instruments to seize up.
Even if a bank held a healthy portfolio that was performing flawlessly, there was no way to value it because no one was buying. This triggered a wave of write downs by even banks that wisely had shunned sub-prime loans, causing the fire to spread. Balance sheets that had been fine were suddenly upside down, forcing the banks to curtail lending because, on paper at least, their net worth had collapsed.
Interestingly enough, this scenario is hauntingly familiar and played itself out during the last banking crisis ” the savings and loan meltdown in the 1980s. In that crisis, one of the key factors was also an accounting change. For decades, savings and loans had been allowed to carry a line item on their balance sheet equal to what we commonly call “customer good will.”
Keep in mind that a bank’s ability to lend is determined in part by its net worth. If a bank counts an intangible asset such as good will (or the long-term value of an income stream from a portfolio of mortgage loans) on its balance sheet, it can loan in relation to its bottom-line net worth.
Then one day, a new set of accounting standards came out that demanded the value of a bank’s good will be wiped off the bottom line of the balance sheets. This suddenly made many savings and loans insolvent in terms of debt to net worth. This triggered the collapse of the savings-and-loan industry.
Sometimes, it’s not how much money you have ” it’s how you count it.
Chris Neuswanger is a loan originator with Macro Financial Group in Avon and can be reached at 970-748-0342. He welcomes mortgage-related inquiries from readers.