Mark to Market

My wife and I sat down with Bob, our stock broker / financial advisor, yesterday and talked about the end of the world as we know it. One bit of insight that Bob shared with us is that banks are required to carry the value of the collateral for the loans they make at market value. Or at least they were. The rules might be changing a little bit.

When banks make loans, they require some collateral as insurance against the possibility that you will fail to pay back the loan. Cars and houses are typical. The bank holds the title to the car or house until you have paid off the loan. Only then does the property really become yours. If you fail to pay back the loan, the bank can repossess the property and then sell it to recoup their money.

The way banks work is a little bit like a Ponzi scheme, mixed with some religion. Theoretically, banks take deposits of money, and then lend that money out to people who can make use of it. But what actually happens it that they hold the deposits and use that as a basis for borrowing money from some higher authority (The Federal Reserve maybe? The Vatican? It doesn't really matter, some mysterious organization that has the POWER!). The banks then lend out the money they have borrowed.

So why this rigamarole? One word: multiplier. The Higher Authority will lend your local bank up to six times as much money as the bank has on deposit. The bank takes in a million dollars in deposits and pays 2 or 3% interest. They then borrow 6 million from central and pay some interest (prime, maybe?) and then lend out the six million at a slightly higher rate. Say they mark up their loans 3%. The first million they lend out pays the interest on the million dollars they took in deposits, and the interest on the other five million is theirs. 3% on five million dollars is $150,000, enough to hire a couple of tellers and pay the rent on the office. Not very much, but then this is a small example.

The Higher Authority also comes around and checks the books at the banks they lend money to, and one of their bookkeeping requirements is that there is enough collateral on the books to cover all the money they have lent out. And here is the rub. The value of the collateral is not the value it had when they made the loan, it is it's current market value. (Mark the value down in your books as the current market value, or "Mark To Market"). So when the housing market collapses and all those houses they have made loans on lose much of their value as collateral, Higher becomes unhappy and restricts the amount of money the local bank can borrow, which restricts the amount of money the bank can lend, which means credit gets tighter all the way around.

No wonder banks are reluctant to unload houses at their market value. As long as they don't sell the house, they might be able to pretend that the market value is still what it originally sold for, and so preserve their borrowing power with Higher (shorthand I picked up from Abby). I'm thinking they should be renting those houses, but that might entail the same kind of problem.