Economist's Commentary: March 24, 2008
Mark-to-Market and Liquidity Crisis
By NAR Senior Economist Jed Smith
As of December 2007, the economy was in relatively good shape, with the exception of the financial and housing markets. Now, in just a few months, there has been rising concern that ongoing financial and housing uncertainties could slow the economy significantly.
There appear to be three underlying problems in the current economy. First, financial liquidity has been a concern, and the Fed's recent actions to lower interest rates intervene in the investment banking sector has been the response. Second, there appears to be an issue of consumer confidence. In 2007 approximately $23 trillion of the total household assets of $59 trillion was derived from residential housing. In addition, consumers are aware of international and domestic economic pressures. Consumers appear to be concerned about the value of their major asset-their house-and whether they will have jobs. Confidence has declined. Third, there are concerns over the subprime mortgage market and refinancing needs.
First, the Fed's actions involving interest cuts and taking questionable loans off the books is a good start. The second problem, the demand for housing and the support of realistic market prices, will be helped by increased GSE loan limits.
In recent years the accounting profession has been focused on asset valuation in terms of mark-to-market. That is, the original cost of a financial instrument is regarded as irrelevant if its current value has significantly declined. But mark-to-market is based on a thinly traded ABX index which artificially depressed the valuation of riskier tranches of subprime loans. This can lead to unrealistic valuations for financial instruments which are only temporarily depressed in value due to an aberration in the marketplace. It also invites margin calls quickly and leads to liquidity crisis.
Unfortunately, we are seeing what is essentially the equivalent of this type of pricing in some housing foreclosures, where upside-down loans are not being refinanced and are resulting in foreclosures. In some cases it appears that current valuation levels will be regarded as having been unrealistically low in a few years, but currently refinancing is unavailable based on current market conditions.
Additional approaches for refinancing ARMS confronted by unrealistically low valuations needs to be addressed. Proposals include tax credits (this commentary presents the views of NAR Chief Economist Lawrence Yun on tax credits and other proposals) and alternatives to the refinancing of houses (in terms of loan principle reduction or appreciation sharing). The third problem--the restoration of consumer confidence-will be resolved partly as the economy expands as a result of more favorable trade policies, the distribution of the rebate checks, the resolution of financial uncertainties, and the upward cyclical trend of economic conditions.
In short, a mark-to-market approach in financing housing that is temporarily impacted by the subprime situation is not realistic in some cases and leading to unnecessarily liquidity stress. Solving liquidity problems is a good first step, which the Fed has been responsive and fairly precise in bringing liquidity back to the market place. The solution of getting people out of the subprime loans is the second step. The restoration of consumer confidence will likely soon follow.
This is one in a series of commentaries by the Research staff of the National Association of REALTORS®. Read more commentaries >
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