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The Real Reasons Behind The Crisis Part I

By Andy Shaw | January 25, 2010

Originally posted 8th April 2009

It has been said at the moment that if you are not confused then you are not thinking clearly.

The credit markets are frozen and despite the recent surge in the stock market, they remain so. So any recovery in stocks will turn out to be a false dawn until these are thawed out.

There is no shortage of information at the moment to confuse anyone, most of it mis-information which is of course from people in the know who do not understand what is going on or the people in the media who just want to report a story. The reasons for both these two producers of excessive mis-information is that these people still falsely believe this is a normal recession and the credit market bubble has burst and led to the house price bubble bursting, whereas the truth at the moment is quite different from the reporting of the mass media.

I wrote in the summer of 2007 that we should be able to escape a major downturn in prices as the British and American property markets were not the same and that the British one was inherently stronger. However, I then had to write how the American market could end up affecting the British market, yet there was nothing really wrong with it (despite what the media will have you believe).

However, the real issue that brought about this crisis was not the lax lending policies in the US, it was not the ‘new wave’ structured investment vehicles and it was not the house price bubble deflating. The real reason for this crisis was the reason I wrote about a long time ago, when I said that I did not know about a particular law that meant that the banks could be forced to sell that assets at today’s price (mark to market).

This single law has brought about the whole crisis and an accounting reason is all it is. The mortgage market in the US, however, was the catalyst that brought about the crisis.

You Only See Who’s Swimming Naked When The Tide Goes Out

As Warren Buffet says, ‘you only see who’s swimming naked when the tide goes out.‘ Well the tide went out on the property market and exposed the real problem, which was one of accounting. And it is this problem that I am going to try and explain today.

Indeed I did not even know until last March that this law even existed. Had I known that such a ridiculous law existed then personally I believe I would have been able to spot this whole thing coming from a long way off. But then hindsight is a wonderful thing and we all need a slap in the face from time to time.

Well I’ve looked into the origins of this stupid law and I found out that it came about following the stock market crisis of 2000 – 2002. What happened was that when people saw their pensions wiped out, they got very angry and things like Enron were going on, which allowed certain other things to be kept hidden from balance sheets. The lynch squad wanted blood; they wanted to know that this couldn’t be allowed to happen again.

So a few congressmen got together and passed a bill that meant greater transparency, which of course was the buzz at the time. This law meant that people could go to prison, not just for knowingly doing something wrong but for ‘should have known they were doing something wrong.’ Now can you imagine passing a law that meant people could go to prison for things that they did not know they were doing wrong? This brought in a very conservative mindset into the banks and hedge fund reporting practices (ie they valued their assets below what they thought they could get for them).

This bill was not thought through as it was obviously a ridiculous thing to pass, but the problem was the buzz at the time was towards lynching anyone who did not support full disclosure. This meant the bill was rushed through and not thought out. This reminds me of what is going on now – when something is broken and the world screams for justice, governments have a tendency to not just fix it, but to over fix it, which is what they did then and what I think we will see again now (and if you don’t believe me then just wait until after next year’s ‘Winter of Discontent II’).

So they rushed it and they went over the top on transparency, but the property market especially in the US had been covering up a lot of mistakes that the financial markets were making. As the asset values soared they hid their mistakes but then when the tide went out it exposed all of the weaknesses in the models, such as loans of 100% LTV’s to people with no income & no job. Now with an inflating property market people who couldn’t pay their loans simply just sold their home to cover it, but this stopped being possible when the property market in the US started to fall.

Here’s where the problem comes in with the stupid ‘mark to market’ rule. It means that you have to value your assets at today’s prices and of course, you have to take the conservative approach to valuing these as you don’t want to go to prison for the ‘should have known’ rule. As for a property investor, could you imagine ever being one if you were forced to sell should the market go down? Of course not, it is ridiculous.

Having To Sell When The Market Is At Its Weakest

So let’s relate this mark to market rule to property again to put it into our context as property investors.

Let’s say you have a property worth £300,000 and there are plenty of other properties in your neighbourhood worth £300,000 too. But let’s now say one of your neighbours had to sell their house in an emergency. They were a very distressed seller and they had to sell right now, so they took the reduced price of £200,000.

Does this mean that your property is now worth £200,000? Well, of course not, this was a distressed sale. Your home may be worth a bit less because of this new comparable evidence but no more than a couple of percent. Why – because you are not distressed and you are in no rush to sell. In fact, you could easily say it has had no ill effect on your property at all, as you do not have a lender looking to call in their loan – but if there was a chance you could go to prison for saying it was worth the same as the day before then you may automatically down value it by 5%.

However, if we had to play with the mark to market rules then you would now have to say your home was worth £200,000. This is the whole problem and the cause of the whole crisis.

Part II tomorrow,

Best wishes

Andy

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