Derivatives and Marked to Market Regulations

At the heart of the financial crisis crippling the global financial system is an accounting regulation gone awry.

It is called 'marked to market,' which requires banks to value their assets using fair market value instead of the purchase price or future value in their financial statements. The intent of regulators was to prevent banks from inflating their balance sheets as assets were overvalued in a declining market. 

A very basic understanding of how banks operate is vital to understand this issue.  Bank liabilities are deposits, money borrowed from the Federal Reserve, and shareholder equity. The major portion of a banks assets are the loans made to their customers such as car, auto, business and credit card loans. The other portion of their asset base is their cash or cash equivalent portfolio. Since holding cash generates little interest income, banks hold much of their liquid assets in securities such as Treasury bills and bonds issued by Fannie Mae and Freddie Mac called mortgage backed securities. Many larger banks even began writing their own securities called credit default swaps.

When the real estate market started to crumble, home values dropped in value by as much as 35%. Mortgage backed securities and credit default swaps, liquid assets which were bought and sold in the open market, became hard to value.  Banks didn't know how much these securities were worth. Rating agencies didn't understand how these derivative securities should be rated. What was rated as AAA, had underlying mortgages that were in foreclosure.  Even though these securities were paying a good rate of return today, they were losing value over time.

Suddenly, banks weren't able to sell these securities because buyers no longer understood how they should be valued and the market dried up. Suddenly, these derivatives didn't have any value.

Within the last 5 months, financial institutions reported billions of dollars of paper losses as they wrote down these securities to fair market value and were required to raise more money to meet their asset/liability ratio requirements. It was difficult to raise money when banks were taking significant losses. 

Banks access money in two ways. They can go to the Federal Reserve if they meet their capital requirements. In other words, banks need to have a 1:10 capital to asset ratio.  As banks wrote down the value of their assets, they didn't have enough capital to meet their requirements.

Banks alternatively raise money by issuing bonds called commercial paper. These short term securities have been considered very safe investments and allowed banks and large corporations to meet capital needs. As banks began to show massive losses, they were unable to issue commercial paper in order to meet their financial obligations.

When banks are unable to raise money, they can't lend money.  

And the financial system teeters on the brink of collapse.