Archive for September, 2008

Unintended consequence, explained

Tuesday, September 30th, 2008

When the Dow Jones drops 778 points in one day, as it did yesterday, it’s a good bet that even people who aren’t generally tuned into economic news will start paying attention. If that’s you, then you’ll probably hear the phrase “mark to market” at some point and wonder what it means.

Here’s the short answer: It means you’re getting close to understanding what’s at the heart of the current financial meltdown.

Mark-to-market is an accounting term (warning: much financial geekitude ahead), and it’s based on the worthwhile proposition that companies involved in things like commodities and securities should value those assets at the current market price — rather than the price they paid or the price they hope to someday get. That’s a fundamentally sound approach, but like many well-intentioned rules it can have a unpleasant consequence. That’s what we’re seeing now, and it’s the fuel to this economic fire.

Everyone understands that the current problem was caused by the bursting of the housing bubble and the resulting wave of loan defaults and foreclosures, which then rippled through the securities markets. Financial institutions suddenly found that the mortgage-backed securities in their portfolios were worth less than they thought. Problem is, such securities don’t all rise and fall in step. Some of them might be worth only 20 cents on the dollar now, while others might be still relatively valuable. But in the current climate, those securities are radioactive — meaning there is almost no market for them. Thus, they all get marked down to next to nothing, meaning financial institutions have to value their portfolios of mortgage-backed securities at that level regardless of their actual worth. That can push companies that were teetering, but still alive, over the edge.

To help you understand how mark-to-market can wreck things, consider this example (which was cribbed from this recent article in Forbes): Suppose you bought a $300,000 house a couple of years ago, investing $100,000 of your own money and borrowing the rest. Your job is stable, your income is more than sufficient to pay the $200,000 mortgage, and you plan to live in the home for years to come. But when the housing market collapsed, similar homes in your neighborhood started selling for $150,000. It would be bad enough that your $100,000 equity had evaporated. But if mark-to-market rules applied to mortgages, you would immediately be required to come up with $80,000 for the bank — $50,000 for the remainder of the vaporized value of the home, and another $30,000 for the 20 percent down payment it wanted. And remember, you weren’t in financial difficulty until then: You were paying the mortgage and had no plans to sell. But suddenly, you’re facing disaster.

That’s what happened to many financial institutions. They had mortgage-backed securities in their portfolios, and yes, those securities lost value. Unless a firm actually tried to sell them, however, it was only an accounting adjustment — or should have been. But in practice, that adjustment to the books can be all it takes to nudge a company into insolvency.