Increasing taxes on corporations means decreasing net income which means that either 1) shareholders (individuals) earn less on their investment, 2) employees earn less, 3) some employees lose their jobs, 4) consumers pay more for products or services, or 5) the company cuts costs and reduces the value to the consumer — or some combination of these. All of these options harm individuals not corporations. In fact there is no way to harm a corporation because a corporation is just the people who own it, work for it, buy from it, sell to it or are otherwise impacted in some way — all are individuals. In other words, punishing corporations is really punishing individuals.

Of the five options above it sounds easiest to choose #1 which is to let shareholders earn less. The problem is that these shareholders are mostly regular people, not Gordon Gecko or Thurston Howell III. Most “investors” are employees and small business owners with investments in 401-Ks and other retirement plans.

The bottom line is that raising corporate taxes hurts the American worker and takes money out of the pockets of regular people. None of the five options listed above enhances anyone’s job security or helps anyone get a raise.  In fact, the opposite is true.

So the next time you are listening to or participating in a debate about the level of corporate taxes you will be equipped to share the truth that taxes are really only paid by people and not companies.

Character – Self explanatory.  If you have trouble maintaining strength of character none of the other factors matter.  We were considering a loan in the summer of 2011 that was very strong from every angle, except one — character of the borrower.  This was someone used to getting their way and responded very poorly (threatening, yelling) to one of the terms we requested.  The borrower tested the market and realized that this request was standard across all banks.  They came back to us offering a sincere apology after realizing our overall terms were very reasonable compared with other bank’s offers but we were chose not move forward with the loan.  If this borrower made threats early in the process what could we expect after the loan was extended?

Capacity – This is excess cash flow after expenses.  The better the cash flow, the better the chance the loan will be approved.  Cash flow is different from profit.  Profit is an accounting concept and doesn’t have much influence on a loan approval.  One simple way to think of profit vs. cash flow is this — you can’t take profit to the store to buy milk & bread but they do accept cash.  Going more deeply into profit vs. cash flow is beyond the scope of this post but I’ll provide one VERY simplified example that may shed some light.  A company that has low profitability may still be a good borrowing candidate if they have significant non-cash items on the income statement such as depreciation.  If the company shows a net-loss (negative profit) of $100,000 but has $1 million of depreciation then they have $900,000 of positive cash flow.  This example assumes depreciation is the only non-cash item for this company but there are many other factors besides depreciation that can negatively or positively affect cash flow.

Capital – This is another term for Net Worth, which is determined by subtracting liabilities from assets.  Assets are what you own and liabilities are what you owe.  The more capital a company has, the more evidence that there is a commitment to the business.  Lower capital indicates that the owners have taken too much out of the company leaving it without a firm financial foundation.

Collateral – Collateral represents one or more assets offered as security for a loan.  If a loan is not handled as agreed, the bank will convert these assets to cash to pay off the loan.  The more easily the collateral is convertible into cash, the more value it has as collateral.  Two examples:

• “Liquid” assets such as a publicly-traded stock portfolio can be quickly converted to cash to repay the loan.
• An art collection is not as attractive as collateral because the bank has to find & take ownership of the art first and then find buyers.  Certain items of art are only valuable to certain individuals so selling art may not be an expedient process.

Conditions – Conditions represent the overall environment in which the borrower is operating.  If the company recently lost their top three sales people, there may be questions about the future viability of revenues.  Conversely, the bank may be comforted if it sees evidence of employee stability, strong demand for the company’s products/services, and recent successful cost-cutting measures.

In addition to the thoughts offered above, it is also a good idea to communicate frequently with your banker instead of waiting until the annual renewal of your line of credit.  Here are some ideas:

• Include the bank on periodic press releases
• Ask you banker to lunch every few months.  They should ask you but take the lead if they don’t.
• Send quarterly financial statements even if not required in the loan agreement
• Proactively communicate material events in the life of your company — especially negative events.  It is better to mange those communications than have the issues discovered in the loan renewal process.
• Send your banker quality referrals from time to time (you should expect the same from them).  This is a factor that is definitely considered in a favorable light.  The bank is in business to make a profit and if your referrals help the bank then your loan request may be considered more favorably.  The difference will not likely be seen in the approval of the loan (a bad loan request will not be approved no matter how many referrals the bank receives) but instead in more favorable terms.

I hope that helps and would be glad to answer any clarifying questions.  Happy borrowing!

I had lunch recently with a guy who advises mega-investment funds on Wall St. We discussed inflation in relation to money supply and he almost sheepishly said his research didn’t reveal much of a correlation. He said the only consistent correlative factor he could find was the percentage change in the labor force — not the unemployment rate but the number of people in the workforce. As more and more baby boomers are retiring, the pool of workers continues to decline. He even had a chart going back to 1930. Two statistics that travel together are not necessarily correlated but his argument was quite compelling.

His basic contention is that when you are working you are spending; when you retire and leave the workforce you stop spending because you don’t know how long you’ll live and don’t want to run out of money. After hearing his argument I started looking around while at places people spend money like restaurants and malls and there really aren’t very many people 70 or over frequenting these venues. So the logic goes like this — more boomers retiring = less spending. Less spending = less incentive for businesses to start or expand = fewer borrowing needs. Fewer borrowing needs = less demand for loans = lower rates.

There are a thousand other factors that influence rates to varying degrees but that was one I really hadn’t thought about. If he is right and if changes in the pool of workers is THE major factor then we’ll see low rates for at least another few years.

Assuming the above is true, here are some practical issues to consider:
- If you are counting on higher bank deposit rates to supplement your income, look elsewhere because money market and savings rates will be minuscule for some time to come. Check out safe, conservative options like whole life insurance with a reputable company like Northwestern Mutual or Guardian. Ask your agent about over-funding the policy.
- Business and personal loan rates will stay low for at least another 18 months and maybe much longer. No need to rush to refinance your mortgage but if your rate is in the high 4% range or higher look into refinancing now. Rates can’t go much lower.
- Residential real estate prices will remain low for years to come. Don’t look for your home to produce equity from appreciation and don’t think of retirement properties as investments.
- Think “niche” — every major market change creates opportunities for those who can see the big picture and have the willingness & ability to make an investment of time and money.
- If you would like to borrow personally or to invest in your business, interview several bankers. Banks are hungry to make loans right now.

I would enjoy hearing and unique thought on rates or the economy in general so please comment below or send me a note if you have any.

The idea that you can raise taxes on the rich without hurting the employees that work for them is the product of a simple-minded theory-based group of people that in my experience and with few exceptions have never owned a business and never had to make payroll.  This is how a real business owner thinks with regard to hiring:  ”If we’re making a profit we’ll try to hire another person to extend that profit further and we’ll keep hiring until it doesn’t make sense from a profitability standpoint to hire any longer.”  As with many of my examples, that is a bit of an oversimplification and there are certainly exceptions but think about it for a minute and you’ll realize how true it is.

On the other hand, if they are not making a profit they’ll start cutting expenses until they have an economically viable model.  For almost every one of my clients, payroll is the biggest expense which means layoffs are almost always a consideration when expenses need to be cut.  I hope everyone can agree on at least this much.

Here is a fictional example to show how it works in more detail — Take a small business that employs 10 people and for the purpose of the example assume they all do the same thing at this business.  Obviously this is not realistic since responsibilities are spread among sales, administration, finance, etc. but just suspend that knowledge for this simplified example.

Every business owner or team/division manager knows the value each of their employees brings to the company.  In the case of our fictional, simplified company, employee #1 brings the most value and employees #9 and #10 bring the least.  Value may be defined in terms of revenue enhancement or expense reduction but there really is no other way for an employee to bring value in an economic sense.

Before I get to the tax issue, I’ll touch briefly on why those who employ others are justified in expecting to make more than their employees.  It really boils down very simply to risk & reward.  Business owners take risks every day in many forms including taking on personal responsibility for company debt, the personal liability (primarily civil) that comes with running a company, and the fact that they are typically “all in” with the business.  An employee can often simply change jobs (obviously more difficult in a tight labor market) if they don’t like their current role but a business owner doesn’t have the same luxury.  They invest years of their lives in making an enterprise work and if it is not working out for them they can’t just switch to a new company without nearly certain economic loss.  All of that to say that those that take the risk can reasonably expect more of the reward (how much more is up to each individual to decide).

Back to the tax issue……….assume for this discussion that the employer in our fictional example decides that a fair amount to expect in after-tax profit for taking on the risks and hard work is $300,000.  Otherwise, they will shut down the company, give up all of the risks & hard work, and get a job working for someone else even if for a lower amount.  It doesn’t matter if you or I or anyone else thinks this number is fair because this is a decision reserved solely for each individual business owner.

Assume the business owner is earning an after-tax profit of $300,000 which is her minimum requirement.  Now assume her business’ tax rate increases from the current 35% to 39.6% as will occur if the Bush tax cuts are allowed to expire.  Further assume that this will reduce her after-tax profit to $285,000, below her minimum requirement.  Her first move will not be shut the company down but to determine how to cut expenses.  Again, since payroll is typically the largest expense, employee #10 is at risk of receiving a pink slip.

If on top of higher taxes you add dramatically higher health insurance expenses or other factors that further strain profitability, then employee #9 will likely be laid off too.  The other 8 employees that remain, including the owner, will have to work harder to make up for the lost productivity.

This really is the way that real business owners who are facing real economic challenges think and make decisions.  You can argue whether or not any given level of profit is fair* or that employers shouldn’t fire employees but instead personally take a pay cut but in reality the example above is very common.  And in reality, there are tens of thousands of business owners that aren’t making a decision to cut their compensation from $300,000 to $285,000 but instead are running businesses that are making far less.  Many of these individuals are facing very difficult decisions and will have to lay off employees (irrespective of whether taxes increase or not).  Increased taxes will only damage these companies further.

Repeating a sentiment from my last post, this is not a political commentary but instead a simple issue of mathematics.  Like everything else in life, businesses are distributed along a bell curve of profitability.  Many employees of companies in the tail of the wrong end of that bell curve will (not “may” but “will”) lose their jobs if taxes on businesses increase.  The search for the elusive concept of fairness* will harm many of those it is most intended to benefit.

*Life is not fair.  It never has been and never will be.  This part probably belongs in a personal blog and not one for business but, in my opinion, over-emphasizing fairness can be a distraction from the more noble pursuit of simply doing the best possible every day with what we have been given.

Here’s the problem — printing new money ultimately will cause inflation which is most harmful to the poor and those on a fixed income.  Inflation has been held at bay for several key reasons including 1) an enormous amount of cash is sitting on the sidelines waiting for positive economic signs and 2) since people are not spending money, the “multiplier effect” is currently very low.  The multiplier effect occurs when the baker sells a pie and uses the money to buy shoes which allows the cobbler to buy a shirt from the tailor and so on.   When the baker isn’t selling as many pies, the rest of the system slows down too.

When economic activity picks back up it will do so in a relatively short period of time.  People will reinvest their money and the unemployment rate will decline significantly causing the multiplier effect to improve………and the newly printed dollars will still be out there.  The combined effect will result in inflation and some say extreme inflation.  Those who would argue that the Fed can just as easily sell Treasuries as it can buy them (and in the process slow inflation) are missing the point that the Fed and the White House are not opposed to the idea of inflation.

Devaluing the currency (allowing inflation) is, in effect, a method paying down national debt.  If inflation increases by 10%, we will have essentially repaid 10% of our debt.   This is a slight oversimplification but it is a long-standing strategy used by governments with overwhelming debt burdens………just print more money to pay the debt and kick the can down the street by signing the country up for future inflation.

Again, those hurt most by inflation are the poor and elderly who are on a fixed income.  A family that has $2,000 in monthly expenses will now have to pay an extra $200/month for those same expenses.  $200 is a lot for a low income family and can be the difference between eating two vs. three meals a day or deciding they can’t take their sick child to the doctor.

The answer is NOT more government programs or higher taxes.  The answer is for us all as a nation to collectively decide to live below our means.  Unfortunately, since we are already in difficult economic times that will hurt a lot more for some.  For the family that decides to drive an 8 year old car for another three years vs. getting a new car, there might not be too much pain.  For the family that has to decide whether or not to take their child to the doctor, the pain is much higher.

“Austerity” will be a word commonly used over the next few years and for good reason.  There really is a limit to the benefits governments can provide as we’ve seen from Greece and now from Ireland & Portugal.  It is not a political issue but a math formula………too many people draining too much too much from the system + not enough people contributing to the system = insolvency as a nation.

By printing another $600 Billion, the Fed has effectively kicked the can down the street but time marches on and there will be a price to pay eventually in the form of inflation.

The bigger question is when it will all come to an end and get back to “normal”, whatever that means these days.  My guess is that it could literally be 10 years before we start seeing new bank charters being granted on any significant level.  We still have a long way to go before banks are finished working through the bad loans they have now and the regulating agencies that grant bank charters will likely be slow to forget the lessons of the past three years (and years still to come).

The first wave of bank failures was associated with institutions that had heavy concentrations in residential real estate.  This market fell very far, very fast and took many banks down with it.  Early in the credit crisis, many of the banks that were not concentrated in residential real estate touted the fact that they were concentrated in commercial real estate loans and that they were insulated.  Unfortunately for these banks, there problems were just over the horizon.

Commercial real estate is generally valued on the level of rents a property can earn.  During a time of high unemployment there is lower demand for all types of commercial rental properties — office, retail, warehouse, and others.  Lower demand produces lower rents.

Weakness in the commercial real estate market has developed more slowly because leases expire at different times.  Any given property many have a series of leases that expire any time from this year to five years from now or even longer in some cases.  As leases expire in a market like the one we are in, tenants have many options and can lock in lower lease rates.

On the surface this does not seem like a huge problem but a quick analysis reveals the real issue.  Take a typical office building in which the average rent is $20 per square foot.  The total expenses for this building may add up to somewhere in the neighborhood of $17 per square foot and the last $3 per square foot is the profit to the owner (known as “net operating income” or NOI in the real estate business).  In the current market, a building with an average rent of $20/sf in 2006/2007, may only be able to sign new leases with rents of $15/sf.  The owner’s costs of managing a building are relatively fixed so in this example, they are now taking a $2/sf loss but this is far better than letting the space go unleased which would result in a $17/sf loss for that particular space.

For banks that are concentrated in Commercial Real Estate, this is a major issue because the building they hold as collateral is now valued at significantly less than it was at the time the loan was made.  But because leases expire at different times, the cracks in the foundation of the Commercial market have been much slower to emerge than those of the residential market which appeared almost overnight.

This problem will continue for several more years as commercial real estate owners work through the challenges of covering a relatively fixed expense based with lower rents.  Compounding the problem is the increasing number of commercial foreclosures………..If an investor buys a building out of foreclosure, their cost per square foot is lower than that for neighboring buildings and they can make a profit even at much lower rental rates.  This puts owners of non-foreclosed properties at a further disadvantage as they try to compete against properties with a much lower cost basis.  It is a downward spiral that will negatively affect commercial real estate for years to come as well as the banks that have financed those properties.

So what about the banks that will survive?  Where are their loans concentrated?  The best performing loans in the current market are ones to strong individual borrowers and to profitable operating companies.  Contrary to many media reports, banks ARE still lending and many banks never stopped lending at any point throughout the credit crisis.  Generally, credit standards are very similar to what they were at any point in the recent past and banks are still lending based on these standards.  The banks that aren’t lending, in many cases, are avoiding adding new loans because of capital issues (see previous post on capital).

As the economy reemerges (yes, it will reemerge) consumers and commercial borrowers will regain their strength and many of the banks that lend to them will in turn regain their strength.  In the short term however there will be some additional weakness in the market and there will be additional bank failures as a result.

Congress, in their attempt to provide consumer protection, decided banks were making too much off of these fees and that those that were paying them typically were those least able to pay.  The answer was to make everyone to perform a one time opt-in prior to allowing their account to be paid over.  There is no opt-out option.  If you opt in, the bank will continue to pay you into overdraft if necessary but you will also have to continue paying the fees.  If you haven’t opted in yet and want to do so your bank likely has a quick way to do so on their website.  Mine says “Important!  Changes to overdraft service coverage”.

If you want to talk offline to get more info dm me on twitter or send a facebook message.

The Texas Ratio has been widely quoted as a standard measure of a bank’s health but as you will see below it is not an accurate measure.  Below is a high-level, simple definition of the Texas Ratio and then the reason why it is not a fool-proof measure.

The Texas Ratio measures “bad” loans (going bad and already bad) in relation to the bank’s financial strength (i.e. their ability to weather the storm).  The top number in the ratio is the bad loans and the bottom is the bank’s capital & reserves.  If the ratio is high, that means their bad loans are high in comparison to the resources (capital & reserves) they have on hand to manage these loans.

The Texas Ratio is not a fool-proof measure because the top number (bad loans) has the very real potential to be subjective.  Example — a bank knows one of its borrowers will not be able to repay a loan but for reporting purposes the bank can’t afford to add this loan to Non-Performing Assets.  If they do claim it as a bad loan (along with all of the others) the FDIC will have to close the bank.  In order to avoid this, they decide to extended it for three years and made it a “bullet” loan meaning no interest & no principle is due for three years at which point the entire note is due.

This is very typical of the actions of many banks over the past three years and has been cleverly dubbed “extend & pretend”.  The only way this strategy would have worked would have been for the economy and the real estate market to make a truly miraculous rebound but this didn’t happen.  In the mean time, many people were comparing Texas Ratios and judging many failing banks as healthy institutions when in fact these banks’ executives simply had trouble reporting the truth.

For the FDIC’s part, they didn’t have the staff to accurately track every one of these misleading attempts by bankers and many stayed under the radar.  They have though, in my opinion, done an excellent job of managing the banking crisis in a reasonably orderly fashion.  They now have more staff but the gray area in judging whether a loan is good or bad is still there and the Texas Ratio is only a marginally more effective measure today than it ever was.

A better measure?  This is not something I’ve researched at length but there is one measure that I’ve seen more than any other that has had a positive correlation with bank failures — percentage of loans in the construction & development (C&D) category as of mid 2007 (approximately).  Again, this is not scientific but any bank I have personally seen with 45% or more in that category as of that time period has either failed or the rumors are flying about failure or acquisition.  Certainly banks with less than 45% in this category have failed but I’m just providing a general observation.  Additionally, a small percentage of banks with over 45% in this category have been able to raise additional capital which of course enhances their viability.

The true measure of a bank requires significantly more analysis.  For larger publicly-traded banks, the equity analysts make a reasonable attempt at judging the banks and there are plenty of these reports available.  For smaller banks, you have to gather information from Call Reports which every bank (public or private) must submit to the FDIC every quarter — access these at fdic.gov, search “call reports” and follow the directions to pull specific bank reports.  Also, SNL data is a very complete database of all information contained in call reports in a format that is more user friendly but it requires a subscription.

That’s a little more than an explanation of the Texas Ratio.  Please send any other questions you have (related or unrelated).

In December of 2008 I wrote the first of two posts on the Sub-Prime Crisis and have delivered a presentation on the Credit Crisis in 10 cities around the Southeast over the past year and a half.  Preparing for both involved many hours of research and interviewing experts.  ”Experts” may be a bit of a stretch, which I’ll explain below, and is one of the reasons for the title of this post.

A frequent question relates to how we can regulate financial markets in order to avoid future crises and my answer is that we can’t which, sadly, I really do believe.  That is not to say that we shouldn’t try to take every step possible to limit market abuses like the ones that led to the credit crisis that started in 2007* but I really don’t think it is practically possible.  In order to effectively regulate abuses out of the market, three elements must be present:  an informed regulating & legislating community that understands the issues, a willingness on their part to make effective changes, and a relatively static market environment (i.e. rapid changes to structure or business practices are not possible).

[*Note regarding the issues that led to the credit crisis:  It can be argued that governmental requirements on banks and mortgage companies created an environment in which banks felt the need to bundle certain "toxic" assets with other assets and sell them to remove them from their balance sheets.  There is certainly some truth to that claim but there was nowhere near enough of this type of activity to cause the credit crisis.  The real culprit was the ridiculous amount of synthetic derivatives that caused the markets to expand and then burst -- see previous posts Sub-Prime Primer 1 & 2 for more explanation.]

Back to the three elements……..the first one, an informed regulating & legislating community that understands the issues, is the most critical and without this there is no hope of establishing effective regulation.  If you read Sub-Prime Primer 1&2 and articles like The End by Michael Lewis and books like The Greatest Trade Ever you will quickly realize the dazzling complexity of financial derivatives that were created and the enormity of the market for these derivatives.

When I was first researching the topic I contacted several people who were either at or close to the top of mega-investment firms as well as individuals that had sold synthetic derivatives before the crash to inquire about a few basic questions.  At the time I didn’t know they were so basic because I was just learning about it myself but, in retrospect, these were indeed basic questions and not one of these individuals had any idea what I was even asking nor did they know who to send me to in order to get the answers.  That is not to say that the answers are simple because they are not.  In fact, the mechanics are fairly complex but somewhere I should have been able to find somebody to give at least a modest amount of guidance since these were such huge markets.

I ended up pouring through charts, documents, papers, and other literature to find the answers and when I found them I was again dumbfounded.  Again, these are complicated issues but somebody should have known these answers.  In reading books on the subject later, I came across the same thing again and again — very, very few people actually understood the mechanics and issues involved in a market that generated tens of trillions (that’s Trillion with a “T”) worth of these derivatives……..not the people at the tops of the investment houses and not the people that were selling the derivatives.

If only a handful of people in the world actually understood all of the inner-workings of these derivatives, can we really expect that these issues could be understood by regulators.  And can we really expect that these issues could have been explained to Representatives or Senators in a way that  would allow them to craft effective legislation to limit abuses?  I really don’t think so.

Take the Bernie Madoff case for example which was a relatively straight-forward ponzi scheme.  Some of Madoff’s competitors had reasonably good indications years before his arrest that he was indeed running a giant ponzi scheme and provided regulators with a trail of evidence.  If it took regulators that long to come to the conclusion that Madoff was a criminal how much longer would it take for them to understand much more complex issues like the relationship between synthetic collateralized debt obligations and credit default swaps?

And, again, understanding the issues is just the first step.  The real test is trying to craft regulations or legislation to limit the abuses, which is even more complex.  Even if they had the political will to regulate or legislate the abuses out of the market, it is difficult to envision a situation in which this could happen.  For example, would a legislative bill that on the surface looked like a hindrance to the growth of the housing market be very popular?

As if these first two elements wouldn’t have stopped any attempt to regulate abuses in its tracks, the third element, a relatively static market, would have crushed any attempt.  The fact is that regulatory efforts or legislation take time and Wall Street is far too nimble and creative to stand still while a lucrative market is taken away from them.  They would begin with intense lobbying against any such regulation and even if that didn’t work they would simply innovate and adapt to the new environment.  Effectively, they would just create another world of lucrative opportunities that were yet to be regulated or legislated away and the game would continue.  It is sort of like a game of cops & robbers where the cops are not very effective……..every time they think they have the robbers nabbed they are frustrated to learn that they are already 500 miles down the road and nowhere to be found.

I believe that the lawmakers in Washington that recently recommended limiting Wall Street compensation already know all of this.  I believe they know that they will always be 500 miles behind and that the only hope they have is to limit compensation to the point where the real whiz kids of Wall Street will lose the incentive to take major risks in order to have a chance at millions or billions in profits.

And now Wall Street is hiring “quants” at a greater rate than ever before.  Quants are quantitative types (math whizzes) that are focused solely on numbers & trends.  They really don’t care about creating lasting value or even if the value of an investment goes up or down — they just want to calculate the odds and get on the right side of the trade, whether it is rising or falling.  On the surface, this is nothing new since this type of activity has been going on to some degree since markets were created.

The difference is that instead of the credit crisis sobering up Wall Street and helping it return to fundamentals and sound investing principles, it has done the opposite.  There is a new level of greed that has been created by stories of individuals like John Paulson who bet against the housing market and personally netted $4 Billion and made over $20 Billion for his clients.  The new Wall Street wants to emulate John Paulson and others like him to make their fortune and they are ignoring the fact that many more lost huge fortunes in the last cycle seeking the same thing.  And the game continues……….

As I said in the beginning of this post, the regulating & legislating community has to keep trying to do their best to limit abuses but in reality it is becoming more difficult to do so.  For the every-day investor like most of us, this means we need to stay on our toes more than ever.

As you manage your investments (or manage those that manage your investments), keep an eye on markets that seem to be overheated and avoid the temptation to either buy the “hot” investments or fail to sell certain investments that have had a good run.  Personally, I also maintain a higher level of cash than in the past to limit the downside and to be able to take advantage of future market dips.  Of course, this also limits the upside in a rising market but, with the market volatility of the past couple of years combined with the apparently ineffective regulatory community, I sleep better that way.

What is a “toxic asset”?

This generally refers to either mortgage-related derivatives (see previous posts “Subprime Primer I & II for more about derivatives) or loans related to land, lots, and houses that are in foreclosure and held on bank’s balance sheets – see previous post “Why Banks Aren’t Lending” for information about how these ended up on their balance sheets.

What is a “Short Sale”?

A short sale occurs when a bank allows a residential builder to sell a house or condominium at less than the amount the builder owes the bank for that particular unit. Simplified example: a bank lends a builder $200,000 to construct a house. The builder completes the house but cannot sell it, at least not for an amount that would net the builder enough to pay off the bank loan. If the builder gets into financial difficulties and cannot afford to make the payment to the bank on the $200,000 loan the property often goes into foreclosure, meaning the bank takes ownership of the home. Banks don’t like to do this because they typically recover much less than is outstanding on the loan and they also incur legal and administrative expenses. Alternatively, the bank may consider a short sale which would net them a higher recovery on this house. Here is how it would work…….a potential buyer offers $190,000 for the house in the example above. The builder then goes to the bank and asks to have the house released for less than the $200,000 loan amount which is typically required. If the bank agrees, the sale takes place and the bank realizes a $10,000 loss vs. what would likely be a much higher loss if it went into foreclosure. The $10,000 is not typically forgiven but instead remains as a debt of the builder who would much prefer to pay interest on $10,000 than on $200,000.

What is “Mark-to-Market”?

Here is a link that will tell you about this concept: http://en.wikipedia.org/wiki/Mark-to-market

In short it simply means listing assets (“marking” them) on your balance sheet at their current market value. The alternative is to hold them at cost or a previously appraised value. There are arguments on both sides but very few argue with the logic of mark-to-market in general…….how can you argue that companies should list assets at anything other than their market value? This is not the real question though…….. the real question is how strict to get with the application of this principle. Those against a strict application of MTM would say that if you have what is likely a short-term downward blip in the real estate market and you force banks to mark their assets down this will punish banks in an unnecessarily punitive fashion and one that does not reflect reality, at least for many banks. This argument is very logical too.  The challenge is in finding a new standard (modified MTM) that can be applied across all banks that is both fair and reasonably reflects the reality of their particular situation.  This is a very high bar to clear so the default is to maintain the status quo which is a strict adherence to MTM.