The following article was sent out in my October newsletter, and I am reprinting it here, now. Want the latest great info? Subscribe to the newsletter in the box on the Right. This has a lot to do with a video that I just recorded, and will post soon, about the reason to refinance right away, if you are considering it.
Crazy times. I am asked about the causes and ESPECIALLY about the consequences of this crisis every day. So, here goes.
Whatever the political posturing, a plan needs to be passed. The country will not enter “financial armaggedon” if it does not, but things will get much tighter before they get better. Credit markets are frozen and banks are going bust every day. This is not totally because of “toxic” mortgages. This has a lot to do with FASB 157, also known as “mark to market”.
Each day lenders must mark their assets to the marketplace. It’s like you having to appraise your home everyday and if your neighbor was under duress because they got very ill, divorced, lost their job and was forced to sell their home quickly they may have sold it super cheap. Now, does that mean your house is worth that super cheap price? Clearly not. Why? Because you are not under duress. You have the time to sell your home and get a more normal price, which more accurately reflects true market conditions. But “mark to market” does not allow for this, which creates a vicious cycle.
Why is this so bad? Because as lenders mark down their assets the amount that they have loaned previously becomes much riskier in relation to their assets. For example, say a bank has $1 million in assets and say they have $15 million in loans outstanding. Their ratio is an acceptable 15 to 1. But should they take a paper write down of $500 thousand due to “mark to market” requirements, their ratio suddenly changes to 30 to 1. This is because their assets are now only $500 thousand after taking the paper loss, while their loans outstanding are $15 million. And at 30 to 1 this bank is viewed as a risky investment. So the stock price starts to get hit, it becomes harder to borrow, and most importantly harder to make money. The bank is then forced to sell some of its loans to reduce its ratio…at cheap prices. And this makes the vicious cycle continue.
And a quick look at the holdings of these loans show that 95% are problem free. Additionally, the Credit Default Swaps (CDS) that are used with the pools of mortgages, are relatively safe. But this requires a bit of understanding. You see, when a pool of mortgage loans is put together it isn’t just A paper or B paper etc. it’s everything. Its got some A paper, B paper, C paper, and even what looks like toilet paper. An “A” investor buys the whole pool but because they are an “A” investor their safety is greater because they can avoid the first 20% (an example) of defaults. So they own the whole pool but are sheltered from the first batch of defaults, and for this they get the lowest rate of return. As you can figure from here the more risk investors want to take, the higher the return. So the investments are relatively safe, but the accounting rules currently place undue pressure on the banking institutions.
Now add to all this the opportunistic shorting done on the financial stocks, much of it illegal because those shorts did not legitimately borrow shares (called naked shorting), and you exacerbate this whole problem. Thank goodness for the recent temporary ban on shorting in the financial sector. As for the plan the government is the only one who can step in to do this. And they have to do this. And they will do this. The nauseating political posture from both sides is just part of the process.
These are rather high-flying economic realities that, to be honest, many of my collegues in the industry do not understand. And this is our industry. So, on one read, I would not expect the average homeowner to ‘get’ it. Not when the elected officials who need to vote on this do not.
Once this is done it will take some time but the markets will stabilize. As for my industry it will take a bit of time but we will make it through this. Rates will remain attractive and the influx of credit availability will help the housing market gradually improve. This ultimately will be the medicine needed to fix our industry. I am here with you to ride out the storm. Count on me, as I count on you.
There you go. That was written October 1. Now in early January the SEC is considering revising “Mark-to-Market”, and if they do, mortgage rates will rise quite rapidly (and the stock market will rally). The subsequent video will explain the reason for that.
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