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Mark-To-Market: Now I Get It

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January 23, 2009 – Comments (0)

I was on Investopedia, looking for a Keynsian explanation why a rightward shift in Interest Rate vs. Investment also causes a rightward shift in Interest Rate vs. Income.  Incidentally, I found an article on MTM; the light bulb goes on. (Articles > Financial Theory > Mark-To-Market Mayhem). This explains how a bank can be worth tens of $B one day, and be worth zilch the next day, even though there has been no substantial changes in that bank.

You are a financial institution and carry many assets. Question: what value do you carry on your books as to its value? Under MTM rules, you choose the current market value: not purchase price, not book value, or whatever. So, if you have a bond and the interest rate goes up, the value of your bond goes down if you were to sell it right away, and you have to decrease your balance sheet correspondingly. But: what IF you were to hold it to maturity? Under MTM, this would not matter until you actually sold it, so your asset base goes down. This works fine for liquid assets like stocks or bonds, but now, as we just discovered, not so well for thinly traded securities that gets traded only between financial institutions, like: MBS, CDO. What are they really worth, if no other bank will buy it? ¢ on the $? What if, in the end, many of the underlying mortgages pay off?

So, this supplies my missing link:

*Community Reinvest Act “encourages” banks to lend to people with weaker credit.

*FNM and FRE securitizes the mortgages, so you can sell them on the open market. Now, a financial institution can make many more mortgages (even bad ones) than their asset base allows, because they can always sell it.

*Those with lower scruples see this, and start making massive numbers of mortgages to anyone, even if they have really bad credit. They make mountains of money.

*Moody’s and S&P rates them investment grade AAA, and everyone buys them, including those who do not realize that they are quite sensitive to real estate prices.

*Real Estate crashes, and so do these MBS’.

*Due to MTM rules, every financial institution has to take a big asset hit and has to raise mountains of cash, even though many of the MBS’ will end up paying off.

*People cry in their beers, and logon to Fool.com for help.

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