Denver Home Mortgage

If you have been paying any attention to the news lately (and it’s probably safe to assume that most folks with a Denver home loan have been), you’ve likely heard a lot of lively discussion (fighting) about the term “Mark to Market” and if changes need to be made.

So what exactly is Mark to Market and why does it matter? Is this going to have an affect on the housing market in general, and more importantly, how might it directly affect your Denver home mortgage?

We’re going to do our best to give a summary of it below so you can hopefully better undertand it, and more significantly, see how it has played such a important role in our current economic crisis, including the Denver mortgage market. It may come as a surprise to you to see that this accounting rule (i.e. law) has much more to do with the current economic crisis than quite probably anything else.

Before we even look at how Denver mortgage rates get affected, let us first discuss why Mark to Market exists at all

To fully understand Congress’ drive behind the creation of this accounting regulation, we need to look back at the stock market crash of 2000 – 2002.

At that time, before this rule was devised, companies like Arthur Anderson and Enron figured out ways of ‘cooking their books’ to make their balance sheets seem significantly healthier than they truly were. This, in turn, helped their stock valuations to be incorrectly inflated, contributing to the ‘bubble’ that, as we all know, eventually popped. When that occurred,many, many people lost tons of money. To suggest they were unhappy is an understatement. Something had to be done.

The idea of “Mark to Market” accounting was created in an attempt to make things 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 to be sold on a daily basis. For those who opted not to do this conservatively, they put themselves at risk for potential jail time.

Let’s now take a look at how this rule can cause a problem affecting the whole economy, including Denver mortgages.

Between the enormous amounts of money handled by banks – not to mention the wide (and strange) variety of financial instruments they use, – it can be hard to try to get one’s mind around exactly what it is they do. It will be easier to illustrate how this accounting concept works using an analogy more approachable to the rest of us.

Let’s say you live in a neighborhood and all the houses are worth about $200,000. Let’s also imagine your neighbor owns his house outright.

Suddenly, you neighbor has some major medical expenses and needs to sell his house to pay for them. He is in need of his money right away and does not have the time for a Denver refinance, and he isn’t in any position to wait for the best price he can get. Instead of waiting, he sells his home for $150,000 to get rid of it fast, even though it’s obvious that the house is worth considerably more than that.

If you happened to live across the street in an identical house, does the fact that your neighbor’s house sold for $150,000 indicate your house just lost 25% of its value? No, of course not. If you decided you were going to sell your house, you would take the time needed and get a fair market price for it; you wouldn’t be forced into a “fire sale” situation like your neighbor.

However, if you were a public company and were required by law to go by the Mark to Market accounting rules, you, and all your neighbors too, would now be forced to claim that the house you live in was only worth $150,000 and not the $200,000 you know to be the real value.

Now we’re going to look at how this applies to a bank.

Let’s do some more hypotheticals.

We’re going to pretend you have decided to begin a brand new bank, let’s call it YOUR BANK. You get started with a $2 million initial investment to get Your Bank going. Your plan to make money as a bank is to bring in other people’s money as deposits, you will pay them a safe but low return on that money, and then use the money to create other loans, for example Denver home loans, that pay you a higher rate of return. The difference between the two rates is the profit you keep.

Let’s say that out of that initial $2,000,000 in deposits, we created $30 million of loans. Our Capital Ratio (the ratio of loans to capital on hand) is at a respectable 15:1 ($15 million in loans for every $1 million in deposits). This kind of ratio is no problem at all and is totally acceptable by banking standards.

We’re going to imagine that you run your bank by extremely conservative standards, and the Denver loans Your Bank agrees to make are only those of the utmost quality. You require a 30% down-payment (normal is 20%, or sometimes even less), you require a credit score of 800 (this would be a VERY high credit score), you require full documentation on all income and assets and only allow a DTI(debt-to-income) ratio of 10 percent (40% is the industry standard).

It is clear, Your Bank will only make the highest quality Denver loan. And it’s evident. All of your borrowers pay as promised, no one is unhappy and Your Bank is making money. This drives Your Bank stock price higher.

All of a sudden, the Denver real estate market starts to slow down a lot and go soft, and Denver home values start dropping (however, your borrowers still make all their payments on time, with no problem).

However, with the industry wide reduction in home values, you are forced to re-assess the valuation of your total loan portfolio. Now, instead of the loans being 70% of the value of the home, they are at 90% (your equity position in the home just went down considerably). This means these loans are now a lot riskier than back when you had a lot more equity, and because they’re more risky investments, investors are less interested in buying them from you than they were before and therefore they now have less value.

Your accounting team now tells you that, according to law, you must “Mark to Market” if you don’t want to risk a serious penalty (such as jail time!) In their Mark to Market analysis, the estimated value is now at $1 million; it has been cut in in half!

Don’t forget, not one thing has changed regarding your borrowers or your loans (everyone is paying on time so the cash flow is still coming in just as it always has). However you now have to reflect the fact that Your Bank’s ‘value’ has been cut by 50% to only $1 million.

The problem is, you still have $30 million of loans out there, and with a valuation of only $1 million, the capital ratio is now at at 30:1 and that is a LOT different than 15:1.

Alarm sirens begin to go off everywhere because it’s a concern that with just a handful of loans that go bad that you would be forced to cover, you might quickly run out of cash. This could put depositors at risk of losing their savings.

Now you have a situation where the FDIC begins looking into Your Bank and the SEC (Securities and Exchange Commission) is asking questions. Your Bank stock commences to fall quickly. Every one of the financial news networks catch wind of the situation and just add fuel to the fire.

Your Bank is in deep trouble.

The thing is, Your Bank is ‘over leveraged’, and to make up for that you are forced to begin selling off some assets. (Another option could be to try to raise some capital, but when you think about the way the situation appears and your capital ratios completely out of balance, no one is going to be willing to extend you the million dollars 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 was forced to ‘dump’ his house very quickly at a below-market price. As you sell your assets to raise capital fast, at the same time you are minimizing the value (i.e. quantity) of your remaining assets, further skewing your capital ratios even further.

This is the sort of death spiral that is almost impossible to stop once it begins. The thing is, the problem does not end with Your Bank.

Let’s say that my Denver mortgage company (we will call it “My Bank”) bought those assets from you. You were unloading them at such a great price that My Bank felt like we were receiving such a excellent deal that we could not resist, so we bought a whole lot of them.

The issue is, with the Mark to Market rules, the loans My Bank just bought from Your Bank at such a reduced price need to be used as comparables that all the other financial institutions also use to value their assets. So now each $200,000 Denver mortgage loan that My Bank held (not only the ones I bought from Your Bank) are now only worth $150,000 each despite the fact that they were loans that were performing perfectly.

Now the value of My Bank also goes down. This, in turn, negatively affects My Bank’s capital ratios and makes me to have to sell assets fast in order to generate funds… and so the cycle continues.

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

When you think about the scenario above, you might ask yourself, “Why don’t they have everyone just stop buying all the discounted assets from the other guys and just stop the cycle?” This is a fair question.

If the cycle is stopped, not only will some financial institutions fold, but the whole flow of money just stops in general. This is what’s referred to as the ‘credit freeze’. When there is no credit available, mortgage loan originations come to a crawl, car and truck sales basically stop, people are laid off their jobs and the whole economy goes into a recession.

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

The minor recession of 2001 recovered pretty quickly in large part because the Fed lowered interest rates and mortgage lending standards were more relaxed, which ultimately led to nearly $3 trillion worth of cash being extracted in the form of home equity and put right back into the economy.

In today’s world, mortgage guidelines everywhere (not just the ones Denver mortgage brokers are dealing with) are much more restrictive, house values are significantly lower (and have been heading in the wrong direction for quite some time). And as was mentioned earlier, the truth of the matter is that there is just not a lot of money flowing out there for Denver mortgage companies to access for either home purchase loans or for a Denver mortgage refinance.

However…

How about some good news for a change!

4/2/2009 – Today the Financial Accounting Standards Board (FASB) voted favorably regarding relaxing the Mark to Market standard. They will let financial companies to use alternatives such as cash-flow analysis to value assets. This change is going to significantly reduce the write downs banks have had to take on assets and investments like mortgages. This could mean more funds will soon be available to your local Denver mortgage companies. We certainly hope so.