Friday, April 3, 2009

Mark to Zombie

Yesterday marked a major turning point in the future of America's banking system. We received word that the much debated mark to market system is going to be "relaxed."

Up until this point, through all my rants about how terrible the situation was being handled by our leaders, my one positive comment was that they have refused to give in to the mark to market accounting system.

Yesterday they caved.

Imagine that a person walks into a bank to get a loan. He has a stable job, decent credit score, and a good history of payments. The banker likes what they see and then asks to look at their financial statement.

Looking down the banker sees that this person is a homeowner in California. The customer has a mortgage on a home of $750,000. The home today is currently worth $300,000, and a bank would probably lend no more than $250,000 on the home after a down payment. The home also has an option arm loan set to adjust in 6 months. His current interest rate on the loan is 1% that he received as a "teaser" rate five years ago.

His monthly payment on the home when this rate adjusts will go from a less than interest only payment of $2,500 per month to $7,000 per month after the loan adjusts to a principle and interest loan at 6%. He currently makes $6,000 per month before taxes.

The banker looks down at this loan and says, "I think we may have a problem here. I don't think we'll be able to lend you any new money based on your future ability to pay your debt."

The customer looks at the banker and says, "You've got be kidding me. I own a house that is worth $750,000 if I wanted to sell it today, and I have never been late on a payment. Therefore I will always continue to make my payments."

The banker then laughs at the customer as says, "You are marking to model, not marking to market. Come back and see me in a few years after you have declared bankruptcy and straightened your books. We will talk about lending some money then."

This is the problem with mark to "model" accounting. The banks will say that "x amount" is what the debt is worth based on past performance, but a new buyer of that debt is going to factor is what it is worth based on the likelihood of default in the future when they are the owners and they are counting on the interest payments every month.

The problem is not that there are no buyers for the bank's debt. The problem is that they have it priced too high. As I have discussed previously in length, if the major banks were forced to sell their debt at market prices they would instantly be further insolvent and bankrupt. (Needing additional tax payer money) If they do not want to declare bankruptcy, then just like our homeowner above, they will be in a position where no one will lend them new money. (Other than the government with our money)

Japan was faced with this decision back in the 1990's. The could have let the banks fail, forced the bad debt off their books, and moved on with new strong loans. The problem was that no one wanted to do business with the banks because they knew that all the bad debt was still sitting there. They knew at some point they would have to come clean and face the music.

We are now heading down the same path. If mark to market is taken away then all the bad debt will just sit on the banks balance sheets forever, and they will never heal. The free market (businesses other than the government) will not want to associate with them because they will not know what is hidden on the bank's balance sheets. This will cause the problems to go on forever. The United States will just be in a long slow perpetual decline with a crippled, insolvent, zombie banking system.

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