Philadelphia Mortgage Stars

If you’ve been paying attention at all to the news lately (and my guess is that most folks with a Philadelphia home loan have been), you’ve likely heard a lot of lively discussion (bickering) about “Mark to Market” and whether or not changes need to be made.

So what is Mark-to-Market and why does it matter? Is this going to have any affect on the housing market, and more importantly, directly on your Philadelphia home mortgage?

We’re going to try to give a summary of it below so you can better understand what it is, and more significantly, comprehend how it has played such a significant role in our current economic crisis, including the Philadelphia mortgage market. It may come as a surprise to you to discover that this accounting stipulation (i.e. law) has much more to do with the current economic down turn than possibly anything else.

Before we even consider how Philadelphia mortgage rates have been affected, let us first discuss why Mark to Market was even created.

To grasp Congress’ inspiration behind making this accounting regulation, we need to look back at the stock market crash of 2000 – 2002.

At the time, before this rule was devised, companies such as Enron and Arthur Anderson found methods for ‘cooking their books’ in order to make the balance sheets seem a lot healthier than they really were. This, in turn, made their stock prices to be falsely inflated, contributing to the ‘bubble’ that, as we all know, eventually popped. When that occurred,many people lost a whole lot of money. To insinuate that they were unhappy is a huge understatement. Something neededto be done.

The idea of “Mark to Market” accounting was created in an effort to make things significantly more transparent and to ensure fair valuation of companies and all their assets. In a nutshell, what it means is that all assets have to be valued as if they were sold on a daily basis. For those who opted not to do this conservatively, they risked potential jail time.

Let’s now look at how this regulation can create a problem affecting the whole economy, including Philadelphia mortgages.

Between the enormous amounts of money handled by banks – and the vast (and strange) variety of financial instruments they use, – it can be hard to get one’s mind around exactly what it is they do. It will be much more simple to illustrate how this accounting strategy works using an analogy more common to the rest of us.

We’re going to pretend you live in a neighborhood and all the homes are worth right about $200,000. Let’s also imagine that your neighbor owns his house free-and-clear.

Suddenly, you neighbor has some major medical expenses and has to sell his house in order to pay forit. He is in need of his money right now and does not have the time for a Philadelphia refinance, and he isn’t in any position to wait for the best offer he can get. Instead, he sells his house for $150,000 to get it sold fast, even though it is clear that the property is worth quite a bit more than that.

If you lived next door in a very similar house, does the fact that your neighbor’s house just sold for $150,000 indicate your home just lost 25 percent of its value? No, of course not. If you decided to sell your house, you would be able to take the time needed and get a fair price for it; you would not be forced into a “fire sale” situation.

On the other hand, if you were a publicly traded company and were required by law to go by the Mark to Market accounting rules, you, as well as all your neighbors, would now be forced to claim that the home you live in was only worth $150,000 instead of the $200,000 you know to be the true value.

Let’s see how this would apply to a bank.

Allow me to present some more hypotheticals.

Let’s pretend you decided to kick-off a brand new bank, let’s call it YOUR BANK. You begin with a $2 million initial pool of funds to get Your Bank started. Your plan to make money as a bank is to bring in other people’s money as deposits, paying them a low but safe rate of return, and then use the funds to create loans, such as Philadelphia home loans, that will pay you a a higher rate than what you’re paying your depositors. The difference between the two is your profit that you get to keep.

Let’s say that from our $2 million of deposits, we created $30,000,000 worth of loans. Our Capital Ratio (which is the ratio of loans to capital on hand) is at a comfortable 15:1 ($15 million in loans for every $1 million in deposits). This is an acceptable ratio by banking standards.

We’re going to imagine that you run your bank by extremely conservative standards, and the Philadelphia loans Your Bank agrees to make are only of the absolute highest quality. For example, you require a 30% down-payment (industry average is 20% or often less), you require a credit score of 800 (this is a VERY high credit score), you demand full documentation of all income and assets and only allow a debt-to-income ratio of 10 percent (40% is the industry norm).

It is exceedingly clear, Your Bank will only make a superior quality Philadelphia loan. And it’s evident. All your borrowers pay on time, no one is unhappy and Your Bank is making money. This causes Your Bank stock to continue to climb.

Suddenly, the Philadelphia real estate market starts to slow down and go soft, and Philadelphia home values begin to drop (but your borrowers continue to make all their payments on time, no problem).

The problem is, with the industry wide drop in home values, you have to re-assess the value of your loan portfolio. Now, rather than the loans being 70% of the value of the home, they’re now at 90% (your equity position in the home just went down a lot). This makes these loans much riskier than back when you had a lot more equity, and since they are more risky investments, the market is less interested in buying them from you than they were before and therefore they have less value.

In comes your accounting team to tell you that, according to law, you have to “Mark to Market” if you don’t want to risk a serious penalty (like JAIL!) In the Mark to Market analysis, the estimated value is now at $1,000,000; it has been cut in in half!

Don’t forget, not a thing has changed regarding your borrowers or your loans (everyone continues to pay on time so the money is still coming in as it always has). However you now must reflect the fact that Your Bank’s ‘value’ has been cut by 50% to only $1,000,000.

The thing is, you still have $30,000,000 of loans outstanding, so with a valuation of $1,000,000, the capital ratio is now at at 30:1 which is a LOT different than 15:1.

Red flags start going off everywhere because it’s a concern that with just a few loans that go bad that you would be required to cover, you might quickly run out of money. This could put depositorsin danger of losing their money.

So now suddenly the FDIC begins looking into Your Bank and next the SEC (Securities and Exchange Commission) starts in asking all sorts of questions. Your Bank stock price commences to fall quickly. Each of the financial news networks get a hold of the story and just add fuel to the fire.

Your Bank is in some deep trouble.

The thing is, Your Bank is ‘over leveraged’, and to compensate for that you are going to have to start selling off some assets. (As an alternative, you could try raising some capital, but when you think about the way things look and your capital ratios completely out of balance, no one is going to be willing to lend you the $1,000,000 you need).

Since you need to get that money as soon as possible, you find yourself in a similar situation to that of your neighbor who needed to ‘dump’ his home quickly at a below market price. As you sell off your assets to raise capital quickly, at the same time you are reducing the value (i.e. quantity) of your remaining assets, further skewing your capital ratios even further.

This is a kind of death spiral that is almost impossible to stop once it gets started. The thing is, the problem does not stop with just Your Bank.

Now let’s imagine that my Philadelphia mortgage company (called “My Bank”) purchased those assets from you. You were offering them at such a discount that My Bank felt we were receiving such a excellent deal that we could not resist, so we bought a lot of them.

The issue is, with the Mark to Market rules, the assets My Bank just acquired from Your Bank at such a good price must be used as comparables that all the other financial institutions also use in order to value their assets. So every $200,000 Philadelphia mortgage loan that My Bank holds (not limited to just the ones I bought from Your Bank) are now only worth $150,000 each despite the fact that they were loans that were performing just fine.

So now the value of My Bank also goes down. As this happens it disrupts My Bank’s capital ratios and makes me to sell assets as fast as possible in order to generate money… and so the cycle goes on and on.

It is easy to see how quickly and wide spread the problem gets, despite the fact that there were not necessarily any ‘bad business decisions’ that were made. It is all caused by good intentioned, but over-reaching, accounting rule.

When considering the scenario above, you might ask, “Why don’t they have everyone just quit purchasing all the discounted assets from the other banks and simply stop the cycle?” This is a fair question.

When the cycle is stopped, not only do some financial institutions go under, but the whole flow of money just stops. This is what is referred to as the ‘credit freeze’. With no credit available, mortgage lending comes to a crawl, car and truck sales all but stop, jobs are lost and the economy slips into a recession.

We have been in, and gotten out of a recession in the past. Why can’t we do the same thing we did the last time?

Our ‘mini’ recession of 2001 recovered relatively quickly because the Fed brought down the interest rates and mortgage lending standards were considerably more relaxed, which led to about $3 trillion worth of money flow being withdrawn in the form of home equity and put right back into the economy.

In the world of today, loan guidelines everywhere (not just the ones Philadelphia mortgage brokers are dealing with) are a lot more restrictive, house values are way lower (and they have been headed in the wrong direction for a while). And as was mentioned above, the unfortunate truth is that there is simply not much money available out there for Philadelphia mortgage companies to access for either home purchase loans or for a Philadelphia mortgage refinance.

However…

A bit of good news for a change!

April 2, 2009 – Today the Financial Accounting Standards Board (FASB) voted favorably in regards to relaxing the Mark to Market standard. They have decided to let financial institutions to use alternatives such as cash-flow analysis in valuing assets. This change will significantly reduce the write-downs banks have needed to take on assets and investments like mortgages. This might just mean more money will soon be available to your local Philadelphia mortgage companies. We’ll hope so.