The Swiss bank, UBS AG, announced this week it would take a $19.1 billion write-down on US mortgage assets it owns and Germany's largest bank, Deutsche Bank, announced it was taking a $4 billon charge against profits for the same reason.Â This is more of the bad news we have heard since the sub-prime mortgage mess starting infecting the world's credit markets.Â Banks, hedge funds, investments banks and other holders of various types of debt instruments have been busy writing down the value of their assets, and, accordingly, their profits.Â This cascade of bad news has resulted in a credit panic and near freeze of credit markets for businesses and families and wiped out almost $2 trillion in stock market values.
Publicly traded firms are required to make timely pubic announcements of any significant events that negatively affect the value of their assets and liabilities or current and future profits, and to make accounting entries on their books reflecting the new value. If a bank is holding a total of $100 million in home mortgages and there is a sharp decline in the value of those homes, they must "mark to market".Â That means they must reduce their asset value of the mortgages to their "market" value, if one can be determined, and reduce their profits by the difference between their original value and the current market value. Often, because of the credit and debt panic, they could not establish a market price because there were no buyers, and, as a result, overestimated the amount of write-downs they had to recognize.
To bring this down to a personal level, lets assume that you own your home free and clear and, according to your local real estate market, it is worth $150,000.Â Then the major employer in your town closes down and terminates thousands of workers.Â All property values will decline as a result. Your home's market value declines to $125,000.Â You feel poorer, and if you were a publicly owned business, you would be required to reduce your profits by the $25,000 for that year.Â
But what if you couldn't establish a market price because you could not find anyone who would even make an offer on your home? Does this mean your home is worth zero?Â To someone who is owed money there are two basic risks: the risk of time and the risk of loss.Â If someone owes you money and takes longer to pay than originally agreed, that is the risk of time.Â If the debtor cannot pay you at all, that is the risk of loss.Â Many homeowners will simply have to wait for the housing markets to stabilize to see their home values recover, a process that could take several years.
Since the banks and other firms that held some of the millions of questionable sub-prime loans, worth an estimated $200 billion, could not quickly and accurately determine their current value, they had to made estimated entries to adjust their books, setting off a worldwide credit panic.Â Now that the credit markets are starting to settle down, many of those write-downs will have to be adjusted to more accurate levels, resulting in write-ups that will increase profits later quarters of 2008 and in 2009.Â
As an example, when the Fed bailed out the investment banker Bear Sterns, they exchanged $30 billion in debt instruments owned by Bear Sterns for the same amount of US Treasury bills, avoiding the bankruptcy that loomed.Â Ben Bernanke recently told Congress that the Fed believes that all of the $30 billion in assets they took from Bear Sterns will be paid in full.Â In other words, there was never anything seriously wrong with Bear Sterns assets, it was just the result of the fear and panic that was sweeping the world credit markets. The markets emphasized this point when JP Morgan's offer of $2 per share for Bear Sterns, a bargain basement price, was bid up to over $10 per share.
Major revisions have been announced to the regulation of the financial markets that will take years to implement but will not solve the current credit market problems.Â This sub-prime crisis is the direct result of a lack of smart, rational regulations on mortgage brokers that allowed an unjustified granting of mortgages to people who were not financially capable of making the payments they agreed too.Â
Unemployment and a general economic slowdown is the natural result of the excesses of the sub-prime mess and will affect all of us in someway.Â We always hear the complaint about how government regulation hamper business expansion, but this current credit crunch and related economic slowdown are the major price all of us are paying for the lack of sound regulations to prevent these kinds of fraud and excess. Hopefully, the installation of new regulations, including regulations on investment banks, will prevent another replay of the mess, but the regulations have to be monitored to be sure that reflect the current needs of world financial system for safety and stability and will not over regulate the markets.