Toxic Assets, Short Sales, and Mark-to-Market

Here are answers to a few questions I’ve received recently………

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.

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