Categorized | economy

Top Ten Myths about the Economic Downturn*

*Well, one, actually, but who’s counting in this panic?

In a previous post, I started ticking down ten misconceptions many of us, especially those paid to have an opinion, seem to be laboring under as the economy continues to head south and our fearless leaders continue to head nowhere. Today is our special banking edition, turning the spotlight on all the fancy and fantasy conjured to keep us sleepless at night. So, with no more excuses, on to number five:

The banking system is insolvent
This is not so much a falsehood as it is a not-quite-so-hood. Still, that’s no reason for people who should know better, like Yves Smith, to shout we’re-all-going-to-die nonsense in crowded theatres (“The banks are insolvent. Got that? Insolvent.”) It’s nice to get the point across, but not at the end of a shiv. Others, like Paul Krugman, are more on the mark when they talk about banks being “technically insolvent,” but the spoonful-of-sugar “technically” does little to soften the emotional explosive of “insolvent.” It’s kind of like being “technically murdered” or “technically divorced” or “technically bombed back into the stone age.” You’re either one or the other. “Technically” does not technically find a middle ground between the two.

And it certainly doesn’t help when the culprit behind the banking system’s “insolvency” is given the Jason Part 15 name of “toxic” assets or its Stuart Smalley cousin, “troubled assets.” If we were to actually find an accurate name, one that described the thing as it is without mixing in a whopping dose of atavistic fear, we’d call these “unsellable” or “unmarketable” assets.

Most of these “toxic” assets are securities that have been packaged from individual home and commercial mortgages based priced primarily on the underlying risk (by “priced” I mean the rate of return on the securities based on the price relative to the face value and the interest paid by the security). The purpose of these securities was to attract investors into the home and commercial market; they were a highly efficient mechanism for attracting funds to pay for mortgages. However, the prices turned out to be woefully low relative to the risk, a fact investors didn’t realize until borrowers started defaulting and the securities began going belly up.

Mortgage securities are unique in that they lose value all at once. A security packaged from individual mortgages can tolerate a certain amount of payers defaulting; however, once defaults reach a critical percentage, the entire security loses all of its value. Not some of its value. All of its value. If a bank held one of these securities, the value of the security went to zero. No argument, no glossing, no excuses. Zero.

But only a small percentage of mortgage holders have defaulted. Most mortgage-backed securities are as good as the day they were bought. However, as a result of these two things (the securities were unbelievably mispriced relative to the risk of loss and the loss suffered is total), nobody could agree what the value of these securities were anymore. Buyers wanted them at considerably less than what sellers were willing to sell for.

Let me illustrate with an example.

Suppose you purchase a house in Sylmar, California, for $500,000 with a $400,000 mortgage. On your balance sheet for that day you list the house as an asset ($500,000) and the mortgage as a liability ($400,00). You are worth $100,000.

You find a renter. He pays you more than your monthly mortage payments, your insurance, your property taxes, and your maintenance expenses. So the house is making money for you.

Now suppose that a huge fire sweeps through Sylmar — as happened a few months ago — and burns several houses to the ground. It doesn’t burn all houses to the ground; in fact, it doesn’t even burn a significant fraction to the ground. But the houses it does burn down are gone. Value=0.

Your house is spared. However, because of the big fire, no-one wants to buy houses in Sylmar. They fear that if they buy a house in Sylmar, it will burn down and have no value.

So, in this market, you decide to put your house up for sale. Your realtor and an assessor that the realtor hires values the house at $400,000. However, after sitting for months on the market, no-one buys the house. You get a couple of loony offers, though. You see, there are some folks out there who are well aware of the fact that no-one is buying houses in Sylmar. They figure they can go in there and get houses super-cheap from desperate homeowners who absolutely, positively must sell their homes at any price. So one person gives you a $100,000 offer, another $90,000, and another $50,000. You don’t take those offers seriously. It’s not even worth your time to say, “Get lost!”

Here’s the dilemma you face: if you had to sit down and do a balance sheet of your wealth, how would you value the house? Keep in mind that your house hasn’t changed. It’s in exactly the same shape it was when you bought it. It’s generating revenues (the rent paid by your tenant) and profits (the difference between the rent you collect and your expenses, i.e., mortgage, insurance, maintenance, taxes). Nothing has changed except people’s impression of the risk of owning a house in Sylmar.

Is the house worth what you paid for it? Do you value the house at $500,000? Is the house worth what the “experts” say it’s worth, $400,000? Or is house worth the highest offer you received on the market — $100,000 — even if you would never in a million years sell the house at that price?

If you value the house at $500,000, you have $100,000 in equity (the difference between the value of the house and the mortgage). If you value the house at $400,000, you break even on your balance sheet, but you have no equity in your house. If you value the house at $100,000, however, you are “technically” insolvent — the liabilities side of your balance sheet is way bigger than your assets side. If you sold the house at $100,000, you would have to pay off a mortgage of $300,000 and, because you can’t, you go bankrupt.

But why would you do that? As long as a.) the house doesn’t burn down and b.) your tenant keeps paying rent, why would you take a crazy offer of $100,000 and go bankrupt?

Congratulations! You have a toxic asset on your hands.

This is exactly the dilemma faced by banks holding mortgage-backed securities (and exactly the dilemma that Geithner’s plan kicks down the road rather than solves — one reason Wall Street voted with its feet in disapproval). In fact, it is this dilemma that has tanked the economy, locked up the credit system, and been the primary reason over a million people have lost their jobs in the last few months. How do you value these securities when they’ve become unsellable?

Think of your house in Sylmar. The price you paid for the house w’ill call the “face value” of the house. This is the value, by the way, on which you initially based the rent. In other words, your tenant is paying a rent based on your house being worth $500,000.

However, the “experts” think your house is worth less than the “face value.” They use a formula to determine the value of whatever complexity. In financial terms, this is called “mark-to-model value.” The problem with mark-to-model, of course, is that there are all kinds of models to use and there are just as many ways to “cheat” to get the highest value you can. In fact, your realtor will probably “cheat” to try to get the highest value since they make a percentage commission on the sale. “Mark to model” is the method of asset valuation that, among other things, allowed Enron to cook its books, cheat all their creditors, and rack up far more debt than anyone would otherwise rationally give them.

What your house would actually sell for on the market right now is, of course, the highest offer you received, $100,000. This is the “mark-to-market value.” You’d never sell at that price in a million years, but that is the current market value of the house since no-one wants to buy a house in Sylmar. However, because people cheat on mark-to-model, the government has told you this is the only way you can value your house.

Think about what’s going on here. Nothing has changed about your house. It’s still making profits for you. It hasn’t burned to the ground. The only thing that’s changed is that people now think that houses in Sylmar are much more likely to burn to the ground than they previously thought. That’s it.

You’re only in trouble if your situation gets so desperate that you have to sell the house and take whatever offer comes your way.

And that’s where the banks and thrifts stand. They are holding perfectly fine mortgage securities and other assets that are performing just fine, thank you. The market’s perception of these assets’ risk has changed dramatically, so the mark-to-market value has become so low that only the most desperate would sell at that price.

So, even though these securities are performing perfectly fine, their mark-to-market value has declined so greatly that many banks are now “technically” insolvent. This is an issue, of course, only with banks that are or will become so desperate financially that they have to unload these securities at market prices. And that desperation has more to do with other assets on their books, such as their own mortgages or loans, than it does with the mortgage-backed securities that they own.

Some of these banks are currently desperate. Some will be desperate in a short time. Some will never be desperate.

The banks are more or less in the same situation you are with your house in Sylmar. If you get desperate enough to sell or your house burns to the ground, you become “actually” rather than “technically” insolvent.

Why did Lehman go bankrupt? They moved into the desperate column and became actually insolvent.

And that, in a nutshell, is the trillion dollar problem that caused the crisis and is at the heart of TARP and Geithner’s new doughnut-hole plan. Until we find a way to deal with these assets — either by having the government guarantee them (which would help set a stable, acceptable market value for them), acquire them (and hold them until there’s an acceptable, stable market value), acquire the banks that hold them (which would, in effect, be guaranteeing those assets as the government would absorb the losses), or find some other way to set a stable, acceptable market value in some other fashion — we’re stuck. Alternatively, the government could find ways to keep banks from getting so desperate that they have to sell those assets and become “actually,” as opposed to “technically,” insolvent. This, of course, was the primary rationale behind the $250 billion CPP, which provided capital to all banks, healthy and unhealthy alike.

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One Response to “Top Ten Myths about the Economic Downturn*”


  1. […] have contributed to the rapid decline in the financial health of many of our banks. The first, as I discussed earlier, was the uncertainty surrounding the actual risk of mortgage-backed securities which has rendered […]

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