Real Estate For Atlanta Blog

As I write this blog post, the DOW is up almost another 200 points. One of the major factors that is causing this Wall Street rally is the recent announcement by the FASB (Financial Accounting Standards Board) that they will be relaxing the current mark to market standards for banks. In order to understand why this news is so important to Wall Street Investors and to the housing market, it helps to understand what this accounting rule is and why many economists believe that it was a major culprit in leading us to the financial crisis that we are currently in. The mark to market accounting rule simply states that companies must value all of their assets at a value that could instantly be obtained in the current market. The most recent sale of a similar asset is used under the mark to market rule to determine the value of an asset on a balance sheet. Banks typically fund loans for businesses as well as home loans and personal loans. In order to free up their cash so that they can make additional loans, banks then bundle together these loan assets and sell them to Wall Street investors. Of course, the price that investors are willing to pay for these assets is going to be determined by their value on the balance sheet.

These days, we hear a lot about how subprime loans that shouldn’t have been made are causing our financial crisis. This explanation is perhaps an over-simplified and inaccurate assessment of the real problem. In reality, the so called sub-prime loans were only a very small percentage of the loans that were made in the previous few years leading up to this financial crisis (I remember reading somewhere that it was about 6% of loans; but don’t quote me on that). Furthermore, some banks were much more heavily in the sub-prime business than others and many did not do any sub-prime loans and never made a single loan that had more risk than the bank or any investor should realistically take. Still, in part because of the mark to market accounting rules, the values of all mortgage backed securities were devalued by the few bad apples. The mark to market accounting rules did not take into account whether a loan was sub-prime or not or a borrowers likelihood of default. Instead, the rule forced banks to value all mortgage securities the same. Therefore, when the market started to slow down and investors finally realized that mortgage backed securities were not the risk-free investments that they were touted to be, they quickly lost interest in the bad loans; which is perfectly understandable. So, the banks that had a lot of sub-prime loans were no longer able to find investors who were willing to buy these loans to free up their cash to make new loans. They were forced to sell them at very low prices and, truthfully, that is all those types of loans were really worth. However, other banks that had little or no sub-prime loans on their books now had to follow the mark to market rules and value all of their mortgage securities at the same value that the toxic assets were sold for. In essence, even the perfect loans with 20% down, dual income, and co-borrowers with 800+ FICO scores were devalued by the other bad apples in the bunch. This caused otherwise very healthy banks to appear on paper to be financially insolvent. Banks are required to maintain a certain level of “health” in order to comply with regulations; so many were forced to sell off other assets (equipment, etc.) at fire sale prices in order to boost their balance sheets to levels that would allow them to comply with the regulations. In doing so, they devalued their competitor’s similar assets further and made their balance sheets look even worse. This continued in a downward spiral until we got to where we are now.

Finally, the accounting standards have just been revised to allow assets to be reported based on what they would be worth in a normal (non-distressed) sale. In this way, if one bank is in trouble and has to fire sale their assets, they will not necessarily devalue their competitor’s assets by nearly as much and the system will do a much better job of separating out the banks that are really in trouble from those that are simply being pulled down by others and would be relatively healthy and stable on their own.

There are many critics of this change in accounting rules who fear that it will allow banks to overvalue their assets and get us right back where we were before. It is my belief that this is a HUGE step in correcting the problem we are in today. However, for the long term (after we get back on our feet) we need to find a good compromise. Too much regulation is no good as it causes things like this to happen. Still, not enough regulation can be equally bad as it can lead to the extended periods of over-exuberance and collapse that we’ve experienced. Perhaps one day, investors will learn their lesson and realize that speculative exuberance-based buying AND panic-selling are equally bad and unwise. The right place to be is right in the middle where one should never pay more than an asset is worth due to underestimation of risk; but should be willing to purchase investments that present a fairly balanced risk-reward ratio.

Tags: Home Loans, Housing Market, Lending Guidelines, Real Estate Investing

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