Explanation of why banks have gone under or merged

This by Marc Herrenbruck (No way I could come up with this!):

“Crazy times. Whatever the political posturing, a plan needs 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 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. 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 posture 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 our 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. We just need to be patient. Those who can stick it out will be handsomely rewarded.”

[Update: There have been a couple good comments made on this post and its accuracy. Make sure to check them out.]

9 thoughts on “Explanation of why banks have gone under or merged

  1. Wow, this guy has no idea what he is talking about. The root of the problem is that asset values, including housing, are in a steep decline, and the problem is exacerbated not because institutions are properly reflecting that fact under FASB 157 (which is designed to prevent game-playing with balance sheets) but because they are NOT properly accounting for their assets under the rule. Confidence is undermined throughout the markets and nobody wants to lend to one another since we have no idea who is a good risk and who is not. This whole thing has nothing at all to do with “duress” in the sense this guy uses the term.

  2. agreed anon,

    This guy has no idea what he it talking about. You can’t break this down to the description he puts out there, one duress sale and now we all have to mark for less. It would be more like you bought in a development, no one else did, no one wants the to pay the price you did, the houses all sit empty. What is you house worth?

  3. Whether or not one agrees with the viewpoint, this should be properly attributed to the author – Barry Habib – of The Mortgage Market Guide, a well-respected expert on the mortgage markets and frequent contributor to MSNBC, FOX News and CNBC.

    [Editor’s note: Agreed. Thanks for pointing this out.]

  4. I’d take Mr. Habib’s insight with a grain of salt. Here’s a quote from him regarding the housing bubble.

    Mortgage Market Forecast 2006 by Barry Habib
    Excerpt from the interview:

    “We will enter the fifth year of the anticipated housing bubble. Yes, for the past four years the media has beat the drum on a looming housing bubble. But all the media bubble hype has only served to hurt those buyers who were scared off from purchasing a home earlier and now see how much more those homes cost.

    So is there a bubble? The simple answer is no. But some areas may cool a bit after a torrid run up, especially in the top tier of their price category.”

    Hopefully people won’t actually buy his ‘analysis’ of our current problems as being accurate. He’s first and foremost a salesman schilling for his industry’s livelihood.

  5. Why was this article posted? It honestly should be entirely stricken from the record for its blatant mis-representation or what is happening broadly. And to make predictions about the success of this plan — when even the creators of this plan are on record stating that this may not solve the issue — is preposterous.

    I much prefer to digest my economic facts from those with specialty in the area, or from some of the people that actually predicted the situation (Roubini, Blodget, etc.) — rather than a California Mortgage Specialist.

    I’d like to vote to have this article removed as its content does not match the otherwise superb writing / commentary on tFS.

    PS: leave it – I really don’t care but AM putting my opinion on record. :)

  6. Here is a quote from buffet:

    “Biggest single cause: tremendous residential real-estate bubble. Human behavior leads to bubbles. Everyone believed prices were going to go up forever. Behaved foolishly. We leveraged up: 20% fall in value of $20 trillion asset. That’s $4 trillion. That’s a big deal. And it continues.”

    $700B is a fraction of this problem and may or may not be the solution.

  7. I suppose I am the only one concerned that a mortgage broker is and using someome else’s opinion/published writings?
    This is a sales manager and 20 year veteran of the busines. . .don’t even get me started on the affect that mortgage brokers have had on the market.

  8. This by Marc Herrenbruck (No way I could come up with this!):

    By the way. . .neither could Marc!

  9. This is exactly what happened. Yes it all starts with over priced real estate. But the nuts and bolts answer to what froze up the lending markets is 100% spot on!

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