So what exactly is Mark to Market and why does it matter? Is this going to have any affect on the housing market, and more importantly, directly on your Baltimore home loan?

We are going to do our best to give a summary of it below hopefully so you’ll better understand it, and more importantly, how it has played such a important role in our existing economic crisis, which includes the Baltimore mortgage market. It may come as a surprise to see that this accounting requirement (i.e. law) has significantly more to do with the current economic down turn than possibly anything else.

Before we even consider how Baltimore mortgage rates get affected, let’s first discuss why Mark to Market was even created

To get a grasp on Congress’ inspiration behind the creation of this accounting rule, we need to go back and look at the stock market crash of 2000 – 2002.

At the time, before this rule was created, companies such as Enron and Arthur Anderson found methods for ‘cooking their books’ in order to make their balance sheets appear a lot healthier than they really were. This, in turn, helped their stock values to be falsely inflated, contributing to the ‘bubble’ that we all know eventually burst. When that occurred, a lot of people lost tons of money. To say they were unhappy is a huge understatement. Something had to be done.

The idea of “Mark to Market” accounting was created to try to make things much more transparent and to ensure fair valuation of companies as well as all their assets. To summarize, what it means is that all assets must be valued exactly as if they were to be sold on a daily basis. For those dissenters who decided not to do this conservatively, they put themselves at risk for potential jail time.

Let’s now look at how this rule can cause a problem affecting the whole economy, including Baltimore mortgages.

When you think about the massive amounts of money handled by banks – and the vast (and strange) variations of financial instruments they use, – it can be difficult to try to get one’s mind around exactly what it is they do. It will be easier to describe how this accounting system works using an analogy more approachable to the rest of us.

We’re going to pretend you live in a neighborhood and all the homes are worth right about $200,000. Let’s also imagine that your neighbor owns his house free-and-clear.

Suddenly, you neighbor has some major medical expenses and has to sell his home to pay for them. He is in need of his money right away and doesn’t have the time for a Baltimore refinance, and he isn’t in any position to wait for the best price he can get. So rather than wait, he sells the house for $150,000 to get rid of it fast, even though it’s clear that the property is worth quite a bit more than that.

If you happened to live 2 houses down in a very similar home, does the fact that your neighbor’s house just sold for $150,000 indicate your house just lost 25 percent of its value? No, of course it doesn’t. If you decided to sell your house, you could take the time needed and get the fair market price for it; you would not be forced into a “fire sale” situation.

On the other hand, if you were a public company and had to by law to comply with the Mark to Market accounting rules, you, and all your neighbors too, would now be forced to claim that the house you live in was now only worth $150,000 and not the $200,000 everyone knows to be the true market value.

Let’s take a look at how this would apply to a bank.

Allow me to present some more hypotheticals.

Let’s pretend you have decided to begin a new bank, let’s call it YOUR BANK. You begin with a $2 million initial investment to get Your Bank going. Your plan to make money as a bank is to take in other people’s money as deposits, paying them a low but safe rate of return, and then use the money to create loans, such as Baltimore home loans, that pay you a a higher rate than you are paying to your depositors. The difference between the two is the profit you will keep.

Now we’ll say that from our $2 million in deposits, we created $30,000,000 in loans. Our Capital Ratio (the ratio of loans to capital on hand) is at a respectable 15:1 ($15 million in loans for every $1 million in deposits). This ratio is completely acceptable by banking standards.

Let’s say that you will be running an extremely conservative bank, and the Baltimore loans Your Bank agrees to make are only of the absolute highest quality. You require a 30 percent down-payment (normal is 20%, or sometimes even less), you require a credit score of 800 (this is a VERY high credit score), you require full documentation on all income and assets and only allow a debt to income ratio of ten percent (the industry standard is 40%).

It’s clear, Your Bank will only engage in an excellent quality Baltimore loan. And it is evident. All of your borrowers are paying on schedule, no one is unhappy and Your Bank is doing very well making a lot of money. This causes Your Bank stock to continue to climb.

Very quickly, the Baltimore real estate market begins to slow down a lot and go soft, and Baltimore home values begin to drop (however, your borrowers are still making all their payments on time, with no problem).

The problem is, with the systemic drop in home values, you are forced to re-assess your loan portfolio valuation. Now, rather than the loans being 70% of the value of the home, they are at 90% (your equity position in the home went down a lot). This makes these loans considerably riskier than back when you had more equity, and because they are higher risk investments, investors are less interested in buying them than before and therefore they now have less value.

Now comes your accounting team to let you know that, according to the law, you must “Mark to Market” if you don’t want to risk a serious penalty (such as jail time!) In their Mark to Market analysis, the estimated value is now at $1 million; it has been reduced by 50%!

Let’s remember now, nothing has changed regarding your borrowers or your loans (they all continue to pay on time so the funds are still coming in just like it always has). Now however you now have to reflect the fact that your ‘value’ has been cut by 50% to only $1 million.

The problem is, you still have $30,000,000 of loans outstanding, so with a valuation of $1 million, the capital ratio now stands at 30:1 which is a LOT different than 15:1.

Alarm sirens start going off all over the place because it’s possible that with just a handful of loans that go bad that you would have to cover, you might quickly run out of cash. This could put depositorsin danger of losing their money.

Now you have a situation where the FDIC starts looking into Your Bank and next the SEC (Securities and Exchange Commission) starts asking all kinds of questions. Your Bank stock begins to to fall. Every one of the financial news networks catch wind of the situation and just add fuel to the fire.

Your Bank is in deep trouble.

The thing is, Your Bank is ‘over leveraged’, and to compensate for that you have to begin selling off some of your assets. (You could try raising capital, but considering the way the situation looks and your capital ratios totally out of balance, no one in their right mind is going to be willing to extend you the million dollars you need).

Since you need to get that money as soon as possible, you find yourself in a similar situation to that of your neighbor who needed to ‘dump’ his house very quickly at a below market price. As you sell your assets to raise capital quickly, at the same time you are reducing the value (i.e. quantity) of your remaining assets, further skewing your capital ratios.

This is a kind of death spiral that is very challenging to stop once it begins. The thing is, the problem doesn’t stop with just Your Bank.

Now let’s say that my Baltimore mortgage company (le’s call it “My Bank”) purchased those assets from you. You were unloading them at such a discount that My Bank got the feeling we were getting such a fantastic deal that we could not resist, so we bought a whole lot of them.

The trouble is, with the Mark to Market rules, the loans My Bank just bought from Your Bank at such a good price must be used as comparables that all other financial institutions also use to value their assets. So every $200,000 Baltimore mortgage loan that My Bank held (not only the ones I got from Your Bank) now only are worth $150,000 each despite the fact that they were loans that were performing perfectly.

Now we have a situation where the value of My Bank also goes down. As this occurs it disrupts My Bank’s capital ratios and forces me to sell assets as quickly as possible to generate money… and so the cycle goes on.

It is easy to see how fast and wide-spread the problem gets, despite the fact that there were not necessarily any ‘bad business decisions’ made. It is all due to a well intentioned, but over-reaching, accounting law.

When you think about the scenario above, you might want to know, “Why don’t they have everyone just quit purchasing all the discounted assets from the other guys and just make the cycle stop?” This is a very fair question.

When you stop the cycle, not only will some financial institutions go under, but the whole flow of money just stops in general. This is what’s referred to as the ‘credit freeze’. With no credit flowing at all, home lending comes to a crawl, car and truck sales all but stop, jobs are lost and the whole economy goes into a recession.

We’ve been in, and gotten ourselves out of recessions before. Why don’t we do whatever we did the last time?

The minor recession of 2001 recovered relatively quickly largely because the Fed brought interest rates down and mortgage lending standards were considerably more relaxed, which ultimately led to about $3 trillion worth of cash being extracted in the form of home equity and put back into the economy.

In the world of today, mortgage loan guidelines everywhere (not just the ones Baltimore mortgage brokers are dealing with) are much more restrictive, home values are way lower (and they’ve been headed in the wrong direction for a while now). And as mentioned earlier, the truth of the matter is that there is simply not very much money flowing out there for Baltimore mortgage companies to access for either home purchase loans or for a Baltimore mortgage refinance.

However…

A bit of good news for a change!

04/02/09 – Today the Financial Accounting Standards Board (FASB) voted favorably regarding relaxing the Mark to Market standard. They will let financial institutions to use alternatives such as cash-flow analysis in valuing assets. This change is going to significantly reduce the write downs banks have needed to take on assets and investments such as mortgages. This could very well mean more funds will soon be available to your local Baltimore mortgage companies. We’ll hope so.