Cash for Trash:
Proposed Purchase of Financial Securities

In September 2008, after AIG was threatened with insolvency, Treasury Secretary Henry M. Paulson Jr. proposed that the government purchased many hundreds of billions of dollars in mortgage-related securities.

Possibly the primary reason that the housing and financial crisis exacerbated in September 2008, causing the government to buy  was something relatively simple. And a simple remedy to correct the dire situation existed, but was ignored..

After the great savings and loan debacle of the 1980s, the Securities and Exchange Commission and the Financial Accounting Standards Board (FAS imposed on financial institutions an accounting rule change (FAS 157) that precipitated the financial crisis after the sudden increase in home mortgage defaults.

That accounting rule change required financial institutions to change the value of financial instruments that they held. Formerly, these financial products were valued at what they would be worth at maturity, or when that particular institution decided to sell, which was determined upon market conditions.

The accounting change required financial institutions to mark down the book value of these financial products to what similar instruments had recently sold for, even if they were sold under distress conditions, or when there was temporarily no market for such sales. This change was called “mark-to-marketing,” and would have enormous and catastrophic consequences for the United States after the housing mortgage problems that escalated in 2007.

Fair Value Accounting requires that financial institutions that hold financial instruments for sale, which would include mortgage-backed securities, are required to mark down the value of the products to what a recent sale brought.

Compounding the Temporary Problems

By being forced to mark down the value of assets to isolated fire sale transactions forced financial institutions, which then required the financial institutions to acquire more capital, they had to put more of the products up for sale, That further drove down the market value of financial products that were otherwise valued at near book value when held to more favorable times. The problem was not a cash crisis, but an accounting-created crisis that ignored market realities.

The problem arises when for various reasons there is no market for such products, and the few that are sold are by financial institutions in a cash bind, and which are then sold at fire sale prices.

An analogy could be a home owner selling a house at far below the market value because of factors such as sudden expensive illness, the need to move to another locality, or heirs dumping a property on the market to obtain quick cash. Under the Fair Marketing Rule, every other similar house in the area would have to be valued at that much lower figure, even though given time, a much higher price could be obtained.

Major financial institutions then failed, were sold at fire sale prices to other institutions, such as Bear Stearns, Lehman Brothers, Merrill Lynch, among others. And led to the near collapse of the giant American International Group.

The losses that financial institutions had to post were often more theoretical than real. Some institutions, such as Lehman Brothers and Citigroup, whose underlying mortgages in the CDOs had decreased in value by 15 percent, had to mark down the value of CDOs by 50 or more percent because the market had temporarily dried up.

Institutions that could have held on to the CDOs and not suffer the loss, then had to mark down the CDOs to very low values. This in turn forced the sale of CDOs, further decreasing their book value.

Due to the temporary lack of a market for mortgage-related products after the housing bubble burst, the few sales that did occur were by financial institutions that had a sudden need for cash. So the selling price was at fire sale prices. The mark-to-market rule then required financial institutions that had good cash flow to mark down the value of their financial products that they intended to hold to maturity. In many cases, this harmed the asset-to-liability ratio to fall below what was required by government regulations or by contractual obligations.

And when they marked down the value of these financial products, many financial institutions then did not have sufficient assets-to-liability ratio required by regulators, or credit ratings agencies, or the terms of their various financial agreements. That started the demise of major financial houses that would not otherwise have occurred, and brought about the great financial crisis in 2008.

When there temporarily is no market for the financial product, it is irresponsible to force financial institutions to lower the value, to zero for instance, because no one is buying.

I once tried to sell a 60-unit motel in Yuba City, California, at a time when there was a real estate slump. If I had been forced to sell, when there was no market, I could have been forced to sell for pennies on the dollar, and possibly for the value of the furnishings with the land and motel thrown in free!

Compare Accounting Rules in the September 2008

Financial Crisis with the Great Savings and Loan Debacle

Toward the end of the 1980s, the savings and loans were insolvent to the tune of $100 billion. Their problems expanded throughout the financial industry. If the financial products of these financial institutions had been put on the market where there were very few buyers, the fire sale prices would have been far below what the market would have brought if the sales could have occurred at a later time, after conditions stabilized. If the price-to-market rule had been in effect at that time, almost every bank and savings and loans in the United States would have been legally insolvent. As it turned out, the cost to the taxpayers was far less.

In 2008, thanks to the Fair Value Accounting rules, the United States is in the worst financial crisis since the great depression of the 1930s, and maybe even worse, though it did not yet reach all of the United States.

The suddenly announced plan for the government (that’s you) to buy most of the financial instruments for which there was no market at the time could totally bankruptcy the United States. Especially if the housing market continued to decline in value, as it probably will.

Expecting Presidential Candidates to Describe Their Plans

While all this was going on, presidential candidates Barack Obama and John McCain were asked what they would do for the crisis, expecting an intelligence answer in a 20-second sound bite!