The Chinese have a proverb: "May you live in interesting times." And we are living through interesting times indeed.
Whatever the political posturing regarding the rescue plan, a plan needed to be passed. 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 she got very ill, divorced, lost her job and was forced to sell her home quickly, she may
have sold it super cheap. Now, does that mean your house is worth that super cheap price, too? 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 previously loaned 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 still $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. It's 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 posturing from both sides is just part of the process.
This is not easy to understand for the general public. In fact most politicians don't get this either. That's why it is a difficult yet
critical bill for them to vote on.
Once this is done, it will take some time but the markets will stabilize. As for the real estate and mortgage industries, 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 improve the situation overall.
All loans subject to credit approval and property appraisal. Programs, rates, and terms subject to change without notice. For ARM loans, rate may increase after settlement. Prequalification is not a commitment to lend, a condition of loan approval, or an application for credit. Pre-approvals will result in a loan decision subject to conditions. Consult a tax advisor regarding the deductibility of interest.-- a Division of National City Bank
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