One of the major culprits of the current financial crisis, in my opinion, has been a complex and little understood accounting principle. This accounting principle is called “mark to market”.
I am no accountant and will be the first to admit I don’t fully understand this hideously complex financial accounting standard. So I have to think of it in terms I understand.
For the purpose of this prose let’s suppose you live in a sub-division. You bought your home for $250,000. Your current mortgage balance is $200,000. You are paying your mortgage payments on time and you have no intention of selling your home.
However, the terms of your mortgage is such that every three months the value of your home and your outstanding mortgage balance is subject to “mark to market” accounting.
During the most recent three months your neighbor had to relocate 
due to a job change and she sold her home for $200,000 or 80% of the prior market value. Your mortgage holder contacts you and says “Your home is worth 20% less than it was three months ago and under the terms of our agreement we need for you to reduce your mortgage balance by 20%.” By the way we need this $40,000 today. Somehow you make this payment and you now owe $160,000.
Another three months goes by and one of your neighbors has lost their job, went into foreclosure and the property was sold for $160,000 or 20% less than the last sale. Your mortgage holder comes to you requesting $32,000 and again yes you need to pay this today. You drain your resources and now you owe $128,000.
Over the next three month there were no sales in you neighborhood. Your mortgage holder makes some calls asking investors what they would pay for homes in your neighborhood. Due to the uncertainty they receive indications that investors would only pay $80,000 if they were to purchase today. You mortgage holder then contacts you and tells you we need for you to reduce your mortgage by another $64,000. You pick up the phone and call your Uncle Sam and scream help I need a bailout.
Do you think this is insane?
This is an oversimplification of what has been happening to the financial institutions with the huge holdings of mortgage backed securities. You don’t hear much about this in the media. It is much more fun to talk about evil lenders and irresponsible home owners.
Much of this financial crisis could have been averted and cost a whole lot less money if action had been taken on this financial accounting principle. But why did this happen in this cycle? The rules on this accounting principle were set by Congress just a few years ago; A legislative overreaction after the fall of Enron, WorldCom, etc.
The good news is this week the Financial Accounting Standards Board, this week, has announced some relaxing of these “mark to market” accounting rules.
Crisis leads to Congressional and regulatory over reach that yields huge unintended consequences down the road. What will we reap in the future? Only time will tell.
One imminently facing us on the horizon is the new appraisal requirement for the Market Conditions Addendum. Read my blog on this subject.
Comments are always welcome. I would like to hear your opinion.
Jay Williams
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