[David Waring]

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Now that we understand what off balance sheet entities are and some of the questions surrounding them, the next major topic we will study is the role that something known as mark to market accounting rules are playing in the crisis.

As you have probably heard many times in the press but may not have noticed, the hits that many of these companies are reporting to their balance sheet are coming not from realized losses on these debt instruments held in the off balance sheet entities but from write downs in the value of those instruments.

Accounting rules require that companies account for the value of these instruments by marking them to market or in other words reporting any loss or gain in the instrument’s value in the tradable market on the income statement as if it were a realized loss or gain even if the company continues to hold the instrument. This is a very important point to understand for several reasons.

1. In order for a company to mark an asset to market there needs to be a market for that asset. As there are so many of the major buyers of these instruments are now in trouble the market for them is very illiquid meaning that there are not enough buyers to be able to sell the asset without incurring a substantial loss in value.

2. Because of this the companies that can are holding onto the debt hoping that order and liquidity will eventually return to the market and that when they do the instruments will trade at a price in which the firms feel more directly reflect the value of the underlying asset.

3. The problem here is that some of the less well funded companies are being forced to liquidate these assets to meet margin calls etc and to find a buyer in the illiquid market conditions they have having to do so at prices most firms consider to be way out of line with the value of the underlying asset. These sales however create a chain reaction throughout the system however where the firms that are in trouble have to now write down the value of their holdings to even lower levels taking a hit to earnings.

5. This is a problem for two reasons.

a. The first is that the banks have to hold a certain amount of capital on their books as reserves as we talked about in our last lesson. When they take these write downs this is reflected as a loss so many need to increase capital in order to meet there reserve requirements.

b. Secondly as we talked about in our second lesson in my simple explanation of the subprime crisis series these banks rely on their sound financial conditions in order to borrow money short term to fund this longer term debt that they are holding in these off balance sheet entities. As they have to write the value of their debt down their balance sheet deteriorates. So just as a person with less income is going to have a hard time getting a loan this makes it harder for the banks to borrow money, putting them in a position where they either have to raise capital as we saw with Citigroup and Merrill or sell assets at distressed prices further exacerbating the problem.

There is now a great debate going on now about the role that mark to market accounting rules are playing in the crisis with the true market capitalists on one side arguing that we need to go through the pain now and be much more aggressive about marking all these assets to market at current prices no matter how illiquid the market. The argument against this which is made by the more interventionists is that if this is done many more banks will fail and the entire financial system is in danger of collapsing.

In our next and final lesson in this series we will look at how the Fed is intervening in the market to try and assist the situation so you can decide for yourself whether you think this is a good or a bad thing.

There are many arguments on both sides which we will be covering in our real-time subprime financial crisis coverage which you can find in the financial crisis section on the homepage of informedtrades.com.

That completes this lesson and our three lesson mini course on intermediate topics in the Subprime Crisis. As always if you have any questions or comments please leave them in the comments section below, and have a great day!

[Airelon]

A little bit more than what I commented over at Youtube.

It's a huge ol' Catch 22.

I hear people start saying: "Well, remember, a writedown isn't a loss". Heck, I've said it myself. Unfortunately, some of these folks believe that this means that we now the extent of the damage, and we don't.

What I've been trying to tell people is: Imagine a losing position you have in your account on a market with just horrible fundamentals? And the volume in that market is like: 3

I try to tell people that's what is going on with these writedowns.

I'm stuck on the fence. Some days I want aggressive, other days I realize the danger. The danger is now ballooning into a solvency crisis. But as you say: I just want some semblance of normalacy. I think Ben is just trying to bide some time. "Kick the can down the street" as you say.

[David Waring]

Yeh its definitely an interesting time. I don't know about you but on a side note I have been having major issues with commenting over at youtube. Anyways I tried to respond to you over there saying that there that a good friend of mine in the accounting industry says that there may be some good opportunities here if you can differentiate the institutions that are taking losses because of a true credit deterioration in their portfolio or if they are taking a big writedown simply because there is no liquidity out there right now.

The one thing that is interesting which I am still trying to wrap my head around is even if the liquidity in the market theoretically never returned the institutions that have not experienced massive credit deterioration in their portfolio could simply hold those instruments to maturity receiving the exact same interest stream they would have if the crisis never happened.

It is very hard to find good information about this stuff but one place that is providing excellent commentary for anyone who is interested is Naked Capitalism. One article in particular caught my eye where he talks about a research paper which outlines how mark to market accounting contributed to the bubble on the way up and the deepening of the crisis on the way down. An interesting read entitled Did Mark to Market Create the Credit Bubble?

[Airelon]

You know, it reminds me of trying to measure the economy by transactions rather than actual measurement of goods and services, back in the 20's.

On the YouTube thing? Yeup. Absolutely. Getting all sorts of weird notifications on comments, comments never showing up, etc.