For those of us who are not accountants, can you help explain how bad mortgages work?

BY busadmin  October 7, 2008 at 12:36 PM EST

House under foreclosure; AP photo

Question/Comment: For the non-accountants among us: Hypothesize that a bank has $1000 in bad mortgages (cdos, etc) that have dropped to $100 in value. How does this adversely affect the bank if it simply holds onto them and no longer lends or takes in deposits? Understanding the Fed’s rules regarding that paper loss (not realized) seems to be at the heart of the “credit” crisis.

Paul Solman: Well, the rules aren’t the Fed’s, they’re made by FASB – the Financial Accounting Standards Board. And you understand why they exist, right? So that fly-by-night artists can’t claim any old number they wish on an asset.

I’m a bank, say. I start with $100,000 of my own money – from friends and family, perhaps. I then take in a million dollars in deposits from NewsHour viewers like you and lend it to my cousin Vinnie, who bets it on a horse named Shoe. Vinnie has never been wrong before but, sad to say, the nag takes the turn too wide and the finish: Shoe last.

Uh-oh. Time for my quarterly balance sheet. On one side, “liabilities”: what I OWE, that’s your deposits, plus the $100,000 due my investors. (That’s called “shareholder’s equity”: their stake in the business.) On the other side, my “assets”: what I OWN. In this case, the $100,000 of original capital, sitting in my vault or on reserve with the Fed – plus, of course, the loan to Vinnie.

Now suppose I play it by the book and declare the loan a total loss? Not only are my investors and I wiped out, but so are my depositors, though they’ll get their money back from the FDIC, up to $250,000 per account at the moment (and rising).

My every incentive, in other words, is to hide the loss. And look, Vinnie has almost always been right in the past. So if he borrows a million from some other banker cousin, bets on a horse named Lettuce, and the finish this time is Lettuce by a head – Vinnie will have enough to pay me back, plus the 20 percent I’m charging him on the loan. I’ll not only be solvent, I’ll have profits to report to my investors. Remember, Vinnie is almost ALWAYS right. (Or lucky.)

So, let us think this through. To buy a little time, I report Vinnie’s loan as “performing.” I.e, he’s going to pay it back. Indeed, if I want to be optimistic (and who doesn’t?), I could book the loan as worth what I EXPECT it to be: $1.2 million, since he’s going to pay me the 20 percent in interest as well as the principle.

Those sticklers at FASB want me to use a ridiculous criterion: how much could I get for the loan to Vinnie on the open market if I were to SELL it? Have you ever heard of anything so silly? The market doesn’t know Vinnie’s track record (I use the term literally) the way I do. They wouldn’t give my ANYTHING for it. Dunderheads. But the FASB would see this and want me to mark down the loan to its market price: to “mark it to market.” (Sounds like a nursery rhyme.)

So I’ll just buy a little time until Lettuce wins. I’ve got a computer model based on how often Vinnie has won in the past. So I’ll value the loan to him according to the model: I’ll “mark to model.” (Critics will say scornfully that I’m “marking to myth,” but who takes THEM seriously? They would have me “mark to worst” instead, which just isn’t fair.)

Now you may think I’m kidding about all this, but I’m not. This is precisely the struggle at the hedge fund Long Term Capital Management in the late ’90s, at Enron in the early ’00s, at almost every financial firm in the world in the past few years.

And while the case of my feckless and fictional cousin in an easy one, the others are not. What WILL those mortgage-backed securities eventually be worth? Not EVERY mortgage will default. Suppose even HALF were to; that would still imply at least 50 cents on the dollar, which is why the government says it won’t lose all the money it’s putting into the rescue plan.

So at long last, your hypothetical: the collateralized debt obligations (CDOs) or mortgage-backed securities drop from $1,000 to $100 on the open market. What’s their fair value? As emailer Yasuko Okamoto writes, these transactions were characterized by “fraudulent practices and unscrupulous mortgage brokers.” You want to pretend they’re still worth $1,000? On the other hand, $100 looks like a fire sale price – i.e., unrealistically low.

It’s a judgment call. In its version of the rescue bill, the Senate instructed the SEC to suspend “marking to market” in order to give the financial system more time, a move I believe I suggested on this page some weeks ago. (Not that I think the Senate is reading this, mind you.) The SEC complied before the bill reached the House.

But never forget Cousin Vinnie.