"Mark to Market" affecting the economy

There have been a number of stories in the local media lately about favorable signs in the local housing market. Among other things, home prices gradually are starting to increase, mainly because construction has slowed significantly the demand is starting to absorb supply.

Still, there’s a huge problem that needs to be resolved in the national economy, and soon.

“Mark to Market” works like this: most assets held by financial institutions need to be repriced constantly, to reflect the value of those assets if they were dumped on the marketplace. MTM is intended to avoid the excesses of the 1980s, when banks were loaning much more than what things were really worth and enjoying, for a time, increased returns.

But in the current climate, MTM is causing severe damage in the housing market and development industry. Let’s say a developer is building a subdivision for $10 million. Typically, banks can’t have more than 80 percent equity, so they loan the developer $8 million and he has to come up with the rest. As long as housing prices increase or at least remain stable, this works fine and everyone earns a fair profit

But if market values have declined – let’s say the subdivision is now worth $7.5 million – the bank could have more than 100 percent equity. Under Federally-enforced MTM rules, the bank must reassess the value of the subdivision and demand the developer pay them enough to bring the bank’s equity back to 80 percent. If the developer can’t pay up (a common problem when people aren’t buying homes), the bank must seize the property and sell it for whatever it can get, to cover its losses. The developer just loses his subdivision and the bank loses its investment.

This is good if you’re looking to buy cheap land, but it’s disastrous for the developer and the housing market. These fire sales drive down the market price of land even more, forcing banks to revalue other developments for even lower prices. In theory, the downward spiral would continue until no one had any equity or value left.

Banks don’t like doing this either, as they know they’re cannibalizing the housing market and destroying their future returns. However, banks must enforce MTM to satisfy Federal Trade Commission requirements.

One solution is for people to by more homes. Fed Chairman Ben Bernanke has lowered the auction rate, but mortgage rates haven’t fallen in return. In some areas of the country, regulators are aware of the problem and are hesitant to enforce the letter of the law at this time, as doing so would severely damage the development industry, the banking industry and impair national economic recovery.

There are some regionally owned, privately-held banks with strong capital positions who are not forcing MTM because they know what they could trigger if they do. But if a builder has multiple banking relationships, he could be vulnerable. If banks are publicly traded, they’re under more scrutiny and may feel compelled to enforce MTM as failing to do so could violate their covenants.

We’ve heard about the federal government loan hundreds of billions of dollars to bail out financial markets. In the case of Mark To Market, however, a bailout isn’t the solution. The market may be able to take care of itself with sensible enforcement of rules.