Your Houston Refinance Resource

If you’ve been paying attention at all to the news lately (and my guess is that most folks with a Houston home loan have been), you have probably heard people talking (debating) about the concept “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, directly on your Houston 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 importantly, understand how it has played such a significant role in our current economic crisis, which includes the Houston mortgage market. It may come as a surprise to you to discover that this accounting rule (i.e. law) has much more to do with the current economic down turn than possibly anything else.

Before we even begin to look at how Houston mortgage rates get affected, we are first going to discuss why Mark to Market exists in the first place

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

At that time, before this rule was created, companies like Enron and Arthur Anderson figured out ways for ‘cooking their books’ so as to make their balance sheets appear healthier than they really were. This, in turn, caused their stock values to be falsely inflated, contributing to the ‘bubble’ that, as we all know, eventually burst. When that occurred, a lot of people lost tons of money. To insinuate that they were unhappy is an understatement. Something neededto be done.

“Mark to Market” accounting was created to try to make things much more transparent and to be sure of fair valuation of companies as well as their assets. In a nutshell, what it means is that all assets must be valued as if they were to be sold on a daily basis. For anyone who opted not to do this conservatively, they put themselves at risk for potential jail time.

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

When you consider the huge amounts of money handled by banks – not to mention the vast (and odd) variety of financial instruments they use, – it can be hard to try to get one’s mind around what they do. It will be much easier to describe how this accounting concept works using an analogy more approachable to the rest of us.

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

Unfortunately, your neighbor has some sudden major medical expenses and needs to sell his home in order to pay forit. He is in need of his money right now and does not have the time for a Houston refinance, and he is not in any position to wait for the best offer he can get. So rather than wait, he sells his home for $150,000 to get rid of it fast, even though it is clear that the property is worth more than that.

If you happened to live two houses down in a very similar house, does the fact that your neighbor’s house just sold for $150,000 mean your home just lost 25 percent of its value? No, of course it doesn’t. If you decided you were going to sell your house, you would take the time necessary and get a fair market price for it; you would not be forced into a “fire sale” situation.

However, if you were a public company and had to by law to follow the Mark to Market accounting rules, you, and all of your neighbors as well, would now have to claim that your home was only worth $150,000 and not the $200,000 everyone knows to be the real market 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 decided to open a brand new bank, we are going to call it YOUR BANK. You start with a $2 million initial pool of funds to get Your Bank started. Your strategy to make money as a bank is to bring in the public’s money as deposits, and pay then a low but safe rate of return on that, and then use the money to create other loans, for example Houston home loans, that pay you a higher rate of return. The difference between the two is the profit you get to keep.

Let’s say that from our $2 million of deposits, we created $30 million in loans. Our Capital Ratio (the ratio of loans to actual capital on hand) is at a comfortable 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.

Let’s say that you will be running an extremely conservative bank, and the Houston loans Your Bank agrees to make are limited to those of only the very highest standards. For example, you require a 30 percent down-payment (normal is 20%, or sometimes even less), you require a credit score of 800 (this is a VERY high credit score), you require full documentation of all income and assets and you will only allow a DTI(debt-to-income) ratio of 10% (40% is the industry norm).

It is exceedingly clear, Your Bank will only make the highest quality Houston loan. And it shows. All of your borrowers pay on time, no one is unhappy and Your Bank is making money. This causes Your Bank stock to continue to climb.

All of a sudden, the Houston real estate market starts to slow down a lot and go soft, and Houston home values begin dropping (but your borrowers continue to make all their payments on time, no problem).

However, with the community wide drop in home values, you are forced to re-assess your loan portfolio value. 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 a lot). This means these loans are much riskier than back when you had more equity, and since they are more risky investments, the market is less interested in buying them from you than before and because of that they now have less value.

Your accounting team now informs you that, according to law, you have to “Mark to Market” if you don’t want to risk a serious penalty (like JAIL!) In their Mark to Market analysis, the estimated value is now at $1,000,000; it has been reduced by 50%!

Do not forget, nothing has changed as far as your borrowers or your loans (they all still pay on time so the money is still coming in just like it always has). Now however you now have to reflect the fact that your ‘value’ has been cut by 50% to only $1,000,000.

The problem is, you still have $30 million of loans outstanding, and with a valuation of only $1,000,000, your capital ratio is now at at 30:1 which is a LOT different than 15:1.

Alarm bells start going off everywhere because with just a couple of bad loans that you would be forced to cover, you might quickly run out of funds. This could put depositorsin danger of losing their money.

Now you have a situation where the FDIC is beginning to look into Your Bank and then the SEC (Securities and Exchange Commission) starts in asking all kinds of questions. Your Bank stock price commences to fall. All 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 compensate for that you are forced to start selling some assets. (As an alternative, you could try raising some capital, but considering the way things look and your capital ratios completely out of balance, no one is going to be willing to lend 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 needed to ‘dump’ his home quickly at a below market price. As you sell as many assets as possible to raise capital as fast as possible, 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 very hard to stop once it begins. The other issue is, the problem does not stop with Your Bank.

Now let’s say that my Houston mortgage company (we will call it “My Bank”) purchased those assets from you. You were selling them at such a discount that My Bank got the feeling we were getting such a fantastic deal that we couldn’t resist, so we bought a lot of them.

The trouble is, with the Mark to Market rules, the loans My Bank just purchased from Your Bank at such a good price need to be used as comparables that all other financial institutions also use in order to value their assets. Now each $200,000 Houston mortgage loan that My Bank holds (not only the ones I purchased from Your Bank) now only are worth $150,000 each regardless of the fact that they were loans that were performing just fine.

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

It is easy to see how fast and wide spread the problem gets, regardless of the fact that there wasn’t necessarily any ‘bad business decisions’ made. It is all caused by a well intentioned, but over reaching, accounting law.

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

When you stop the cycle, not only will some financial institutions go under, but the whole flow of money in general just stops. This is what’s referred to as the ‘credit freeze’. When there is no credit available, mortgage loan originations come to a crawl, car sales essentially stop, jobs are lost and the economy slips into a recession.

We’ve been in, and gotten ourselves out of recessions before. Why don’t we do whatever we did the last time?

The minor recession of 2001 recovered relatively quickly in large part because the Fed brought interest rates down and mortgage lending standards were considerably more relaxed, which led to nearly $3 trillion worth of cash being withdrawn in the form of equity from homes and put back into the economy.

Today, mortgage guidelines everywhere (not just the ones Houston mortgage brokers are dealing with) are much more restrictive, house values are way lower (and have been headed in the wrong direction for quite some time). And as mentioned earlier, the unfortunate truth is that there is simply not a lot of money available out there for Houston mortgage companies to access for either home purchase loans or for a Houston mortgage refinance.

However…

Some good news for a change!

04/02/09 – The Financial Accounting Standards Board (FASB) voted favorably in regards to relaxing the Mark to Market standard. They will let financial institutions to use alternatives such as cash-flow analysis in valuing 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 options will soon be available to your local Houston mortgage companies. We hope so.