The End of the Credit Crisis 21 comments by: Alex Trias February 27, 2009 | about stocks: BAC / C / JPM Alex Trias Add to Your WatchlistAbout this author: Profile & More Articles Become a Contributor Submit an Article Font Size: PrintEmail TweetThis Now sit around in a circle, kiddies, and let me tell you the story of the credit crisis. It goes like this.
Homeowner owns a $400,000 home secured by a $500,000 mortgage. Homeowner is very concerned that the value of the home could drop to $300,000 in the next few years, which is when he plans to sell the home, and he does not have the $200,000 in cash to make up the balance and pay off the full mortgage. Currently, Homeowner is thinking foreclosure is the best and only option to avoid going into further debt.
Bank has a worse problem, because Bank has a $500,000 mortgage on its balance sheet but no investor is willing to buy it for more than $100,000. The reason why is because investors know that the security on this loan is worth $400,000 and that it will probably continue to deteriorate in value. More importantly, the investors know that Homeowner has a strong incentive to let this thing go to foreclosure soon, at a time when the underlying property is rapidly losing value. Finally, investors see the value of other mortgages falling rapidly, and don’t want to catch a falling knife.
Now we’re getting to crux of Bank’s biggest problem, which is that under some clever accounting rules, Bank needs to mark this mortgage to market. Bank knows that the mortgage is not worth $500,000, but right now if they went to foreclosure, Bank would get $400,000 because that is what the collateral would sell for. However, under the mark to market rules, the value of this mortgage is not $400,000 – it’s $100,000 because that is what an investor would pay for it.