Little-Acorn
10-02-2008, 11:27 AM
In all the hooraw over the mortgage crisis, financial bailouts of everyone on the planet, etc., the term "Mark to Market accounting" has been tossed around a lot.
I'm no economist, but I asked a friend who is, what that meant. He gave me an explanation that he said was very simplified, leaving out a lot of the more complex things that go on, but capture the essence, he claimed. It is:
Suppose you're running a business, making couches.
If you run a cash business (without Mark to Market), someone says he wants to buy a couch from you. He hands you the purchase price, you deliver the couch, and the transaction is completed. This happens again and again, for various customers. Your couches cost $500 each, and the customers are happy to pay it because you make good couches.
If someone asks you how much your business is worth, you show him the workshop, the raw materials, the tooling, the couches awaiting delivery that afternoon, and the money in your wallet. Add them up, they total $10,000 (you work out of your garage with hand tools), and that's what the business is worth.
With Mark to Market accounting, someone sits down with you and you sign a contract to sell him one couch per month, for five years, for a total of 60 couches. That's a total of $30,000. It's a signed, legal contract, so it's good.
If someone asks you how much your company is worth, you show him all the same workshop, tooling, money etc., and then you throw in that $30,000 contract. The business is now worth $40,000 total.
If you want to take out a loan for something, you can point to your business worth $40,000 as collateral, and get the loan.
You can also do a study on "The pricing trends in couches", and make a prediction that your couches will go up in value and be worth $1,000 each. So now that contract is worth $60,000. So you can now take out an even bigger loan to hire more employees and buy materials for all those couches, brag about having a higher net worth, etc. You can even predict that they will be worth $2,000 each, and show an even bigger company value, get bigger loans etc.
That's "Mark to Market" accounting, in a nutshell. There are many more complexities, but that's the essence.
The problem is, of course, what happens if the prices of your couches don't go up as predicted? Or, what if the guy you signed the contract with, goes bankrupt, or dies, or moves to Tahiti with no forwarding address? You have all those materials sitting around, and you still have to pay your employees and pay back the loan.
I gather that's what's been happening in the mortgage market. People took out loans to buy houses back when house prices were rising fast, so they predicted the house would be worth twice as much soon. And people who formerly couldn't afford the payments, took out Adjustable Rate Mortgages, whose payments would rise if interest rates ever rose. They could barely afford the payments while the interest rates were super-low as they were for several years.
Now, interest rates are going up, and their payments are going up too, and they can't afford to pay them. And with house prices going down as they are today, they can't even pay off the mortgage by selling the house - the money they will get, is less than the amount they owe. So a lot of loans are falling behind (people are missing payments), and some are even being foreclosed. But the banks have the same problem: They can't get back the money they loaned, because the price they get by selling the forclosed house, is less than the money they lent out on it. So people are in trouble, and the banks are in trouble too. Those mortgages are the "bad paper" the govt now proposes to buy, with $700 billion.
Any real economists out there? Is this a fairly accurate picture of "Mark to Market" accounting? I may have left lots out - as I said, I'm no economist.
Comments?
I'm no economist, but I asked a friend who is, what that meant. He gave me an explanation that he said was very simplified, leaving out a lot of the more complex things that go on, but capture the essence, he claimed. It is:
Suppose you're running a business, making couches.
If you run a cash business (without Mark to Market), someone says he wants to buy a couch from you. He hands you the purchase price, you deliver the couch, and the transaction is completed. This happens again and again, for various customers. Your couches cost $500 each, and the customers are happy to pay it because you make good couches.
If someone asks you how much your business is worth, you show him the workshop, the raw materials, the tooling, the couches awaiting delivery that afternoon, and the money in your wallet. Add them up, they total $10,000 (you work out of your garage with hand tools), and that's what the business is worth.
With Mark to Market accounting, someone sits down with you and you sign a contract to sell him one couch per month, for five years, for a total of 60 couches. That's a total of $30,000. It's a signed, legal contract, so it's good.
If someone asks you how much your company is worth, you show him all the same workshop, tooling, money etc., and then you throw in that $30,000 contract. The business is now worth $40,000 total.
If you want to take out a loan for something, you can point to your business worth $40,000 as collateral, and get the loan.
You can also do a study on "The pricing trends in couches", and make a prediction that your couches will go up in value and be worth $1,000 each. So now that contract is worth $60,000. So you can now take out an even bigger loan to hire more employees and buy materials for all those couches, brag about having a higher net worth, etc. You can even predict that they will be worth $2,000 each, and show an even bigger company value, get bigger loans etc.
That's "Mark to Market" accounting, in a nutshell. There are many more complexities, but that's the essence.
The problem is, of course, what happens if the prices of your couches don't go up as predicted? Or, what if the guy you signed the contract with, goes bankrupt, or dies, or moves to Tahiti with no forwarding address? You have all those materials sitting around, and you still have to pay your employees and pay back the loan.
I gather that's what's been happening in the mortgage market. People took out loans to buy houses back when house prices were rising fast, so they predicted the house would be worth twice as much soon. And people who formerly couldn't afford the payments, took out Adjustable Rate Mortgages, whose payments would rise if interest rates ever rose. They could barely afford the payments while the interest rates were super-low as they were for several years.
Now, interest rates are going up, and their payments are going up too, and they can't afford to pay them. And with house prices going down as they are today, they can't even pay off the mortgage by selling the house - the money they will get, is less than the amount they owe. So a lot of loans are falling behind (people are missing payments), and some are even being foreclosed. But the banks have the same problem: They can't get back the money they loaned, because the price they get by selling the forclosed house, is less than the money they lent out on it. So people are in trouble, and the banks are in trouble too. Those mortgages are the "bad paper" the govt now proposes to buy, with $700 billion.
Any real economists out there? Is this a fairly accurate picture of "Mark to Market" accounting? I may have left lots out - as I said, I'm no economist.
Comments?