Credit Crisis Solution

You’ve heard of Fannie and Freddy, AIG, Citi, and FAS 115/FAS 157 (mark-to-market) as being the primary contributors to the credit crisis. Ever wonder how they all come together and the roles they play?

The goal behind FAS 115/157 (mark-to-market) is to keep companies honest in the value of securities which they intend to sell. The market value (vs. historical cost) can be determined through different models (i.e. – Black and Scholes) to determine the appropriate value based on certain assumption (the exception is fixed debt securities which the company intends to and can hold to maturity).

The banks are regulated and required to have certain ratio’s to cover the used to cover 5 C’s of Credit, Character, Cash Flow, Collateral, Conditions and Capital. The purpose of mark-to-market with regard to regulation is related to minimum capital requirements (how a bank must invest their deposits).

These polices are designed to keep the banks liquid, stable, and profitable, but also had unintended consequences. Interest rates are a direct reflection of risk, the higher the interest, the greater the risk. Banks make their money through margins on investments, if someone deposits savings at a rate of 2%, the bank will invest that deposit in a stable 6% investment and earn a 4% margin.

Banks are required to keep a minimum ratio of their assets in highly stable investments (mark-to-market determines the value of those securities). AAA rated securities (highest) offer an additional incentive to banks because their overall leverage ratio requirements are lowered. Public companies (i.e. Citi and Bank of America), have an obligation to maximize shareholder wealth and that’s done through carrying the minimum ratios, and investing the rest in higher interest/risk investments, especially with the incentive that funds are insured by FDIC. Smaller banks, conversely, were more inclined to invest in more stable investments, and thus still strong.

Arise Fannie and Freddie, these government created mortgage companies issued subprime loans to unqualified consumers. Many of these securities were transformed into debt securities and insured through credit default sways (insured by AIG), thus obtaining AAA credit ratings. The idea that these AAA securities lowered the reserve requirement led to a boom in demand, and continual creation of the misguided securities.

This continued incentive of “fraudulent” securities led to the decrease in wealth as people began to default on their mortgages and the insurance companies were overwhelmed. The decrease in value posted to the balance sheets (mark-to-market) accounted for almost $600 billion or because of leverage ratio’s $6 trillion in potential lending.

A few side notes: Investment banks were required to have lower ratio’s than regulated banks leading to the collapse of Lehman Brothers, Merrill Lynch, and Bear Sterns. Additionally, other countries such as Canada remained more conservative on lending, and are stable. For more information on the cause of the credit crisis, and leverage please visit “http://consumerist.com/5157192/hot-cartoon-makes-understanding-credit-crisis-simple-and-fun.