Sunday, October 19, 2008

A Self Made Crisis

What if any is the connection between the government's requirement of mark to market accounting and our current financial crisis?

In the world of our current credit crisis there is an uncertainty among traders and other officials as to the value of the Mortgage Backed Securities(MBS), which are the financial tool behind the credit crisis and are essentially the right to a percentage of the returns from a group of mortgages. Thus as house prices fall more people fall into the category of owing more on the mortgage than the house is worth, which increases the risk of someone choosing to default on their mortgage. This risk of people choosing to walk away from their mortgage, decreases the value of the pool of mortgages, and consequently the value of your share represented in the MBS. As a consequence of the uncertainty of how many foreclosures will occur in a group given pool of mortgages, buyers will only purchase new MBS if they are certain they are not overpaying even in the worst case scenario. Consequently the owners of MBS are not very inclined to sell since they believe that things are better than the worst case scenario. This difference in perceived valuation between the buyers and sellers creates a market stagnation where nothing happens until someone is forced to buy or sell at whatever price they can get. Since buying is almost always optional but selling is not, then the market price, being the price at which the last transaction occurred is buyer determined price. As a result of this organizations such as banks or investment banks, which are required to use mark to market accounting, such as banks and all public companies, must show their MBS investments at this fire sale value. Consequently it is possible that a bank may be declared insolvent under SEC rules and forced into bankruptcy based upon the fire sale market price. As such it is possible that part of the crisis is being fueled not by too little regulation but rather the regulation which prohibits accounting methods designed to be accurate in predicting the value of a bond when there is little to no trading volume in its sector. As a result I am skeptical of the claims made largely by the Obama camp that the credit crisis is completely a result of greed and too little regulation.


Anonymous said...

ok, so I see the issue here pretty clearly--you've got me concerned that something "un-smart" is occurring in the economy but--how does this relate to ME and which candidate will perpetuate or make this worse and who, based on what, can/will make it better?

John the phone guy said...

You have a good point about the surprise effect of the new regulations but how do we determine a true value of an asset in the future? Conventional time value of money discounting works well in stable markets but uncertainty coupled with time can decimate a current value? Do we just "Have Faith" like "W" tells us he makes decisions?

Spencer said...

Although there is a high degree of uncertainty in the markets right now, there are still models which can help forecast the time value of these assets. The assets are being driven down some by the likely decreased returns because of payment delinquency, but one of the largest factors is fear regarding the short term fear of market performance and its implications rather than the long term value of the assets.