DaveJ

Global Capital Asset Death Spiral

Well there is no one cause of the housing bubble. But I would say that you do not need to seek blame in China and not even the Fed funds rate. The biggest reason that prices started going up is just supply and demand and the dynamics of feedback loops. The supply of houses was fairly constant at first and the demand for houses went up dramatically. Why? It is just that people who never would have been allowed to buy houses were now given the chance.

When I was a kid, I remember thinking that what you did in your 20s is that you saved up your money so that you could afford a down payment on a house once you got married at say age 30. However this way of living changed with the new high-debt lifestyle that has grown up in the past 30 years or so. Mortgages became easier and easier to get. Also people were given more credit via credit cards and so could avoid defaulting on their mortgage by borrowing on their cards. The result was a long period of low defaults and low losses as houses appreciated steadily. Low loss rates leads to further loosening of credit standards which allows the next round of bad borrowers in.

This goes on and feeds back on itself. More demand for housing leads to higher home prices which leads to low loan losses and more bank profits which allows (and requires) more loosening of standards.

The result is the final boom and bust of the last five years. The low interest rates played an encouraging part but I think the main cause was just a loosening of credit and the way new buyers entering the market place skewed the supply-demand balance. I would say the low long-term interest rates was more an effect of high profits in the FIRE sector but the Chinese vender-financing of US consumption also played a major part.

Global Capital Asset Death Spiral

There are many problems with mark-to-market. Here are a few examples from AIG's balance sheet. As everyone knows, they have taken huge write-downs from CDS contracts on subprime backed RMBSs. These are marked to market because RMBSs have market prices and that is what is specified by accounting rules. However AIG also has loads of CDS contracts on bank loans. They were written so that European banks could reduce their at-risk assets to comply with Basel II capital standards. If these bank loans (cherry picked by AIG to be well collateralized) default and suffer 80% losses, AIG will start to pay out some cash. In other words, there is almost zero chance of significant cash loss on this portfolio. Since these bank loans are not marked to market, these CDS contracts are marked to model and have no markdowns. However if AIG tried to sell these right now, they would likely get no more than 60 cents on the dollar. Who would be able to take over hundred of billions in assets right now? Then there is the hundred of billions in insurance policies that AIG has. Like all insurance contracts, these are marked to model. Insurance contracts are rarely traded.

So the only difference between their CDS contracts on RMBSs and the other categories of assets is that there exists a market for them, albeit an illiquid one. Does the existence of a market really change the value of an asset? If everything was marked to market then AIG would be insolvent since it can't easily sell its insurance contract on an Eastern European charcoal factory or that policy on an Algerian oil rig. No one else has done the due diligence to know the value of those assets and so no one would buy without a large haircut. But does that mean they are worth less than par? Similarly, if there was no market for RMBs, then AIG could mark up its CDSs on RBSs by about $15B, even with conservative assumptions on loss estimates, and it would be in great financial health.

The situation is the same with the banks. Their loans are not marked to market but rather are marked down only when collection becomes doubtful. Should they be marked to market? If so, then every bank is insolvent right now and in fact would be insolvent just about anytime.

So mark-to-market cannot be the right answer for many assets. You need to consider whether the market is liquid and normally functioning. If the cash flows do not appear to be impaired but there are just no possible buyers then you need to reconsider. As Bill said, a religious observance of mark-to-market can lead to a death spiral that doesn't help anyone. I think time has come when you say, "enough is enough". There has been plenty of punishment dealt out already and so I don't think moral hazard should be our first priority as a nation right now.