Credit markets are frozen. What are the factors behind the credit market freeze? One of the big perpetrators is FASB 157 or mark to market accounting.
What is FASB 157?
FASB 157, pronounced FAZ-BE, more commonly know as mark-to-market accounting is accounting regulation that is designed to bring more transparency to investors about the true financial condition of publicly traded companies. This transparency has gone overboard and is now partially to blame for the credit troubles we are currently experiencing.
How does FASB 157 work?
This accounting regulation forces financial institutions to evaluate their asset levels each day. These rules say that assets have to be valued at the price that the market would pay if the assets had to be sold instantly. In other words, if you have to sell a nice watch at a pawn shop you will not get a fair price. Pawn shops operate on obtaining instant cash so they pay pennies on the dollar in comparison of true market value. This pawn shop or fire sale price is the value FASB 157 forces financial institutions to use to value their assets on a daily basis.
So when a financial institution is under distress and must do a "fire sale" for their assets, the value they receive becomes the market price for all other financial institutions even if they are not under duress. Each institution must maintain certain ratios of assets to loans to maintain a healthy status with the markets called their leverage ratio. So if one institution is forced to sell assets very cheep it affects all institutions leverage ratios overnight. Now their asset values look very low compared to their loans so their leverage ratio increases making them look risky to investors. When in actuality nothing changed other than a fire sale by another institution, but according to FASB 157 it affects their accounting numbers.
Healthy institutions wanting to balance out their leverage ratio must sell loans to bring their leverage ratio back to an acceptable level. Now they quickly sell assets on the market creating another "fire sale" comp. This becomes a continuous and vicious cycle and ends up affecting all finical institutions on Wall Street.
Other factors in the credit crisis are Collateralized Debt Obligations (CDO's) and Illegal Short selling among many others, all together creating a global confidence crisis in the financial sector.
I hope this helps shed a bit of light on a very complex set of problems.
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