Is Another Financial Crisis Just Around the Corner?

Source: Thinkstock

Source: Thinkstock

In 2007, we began to see home prices fall and as a result there was a spike in mortgage defaults. Banks, which had at one time been considered to be among the safest investments out there with stable cash-flow streams and shareholder friendly dividend policies began to report losses. By the following year, the large banks began to face bankruptcy, and all of the so-called “big banks” would have gone bankrupt if they weren’t bailed out. This bailout didn’t simply come in the form of the TARP program from the government. In fact, given the size of the big banks’ balance sheets, $25 billion in bailouts apiece would have been far too little to cover the incredible losses.

The second bailout was a stealth bailout from the Federal Accounting Standards Board (FASB), which, as the name suggests, sets accounting regulations that banks have to follow. In 2009, just before the stock market turned around, the FASB told banks that they no longer had to mark their assets to their market values. Rather, they could assume that they were planning to hold these assets (mostly bonds) to maturity and then mark them to “model,” or guess at their value.

With asset prices so depressed, the banks could say that the market prices were temporary and that they could assume more normal prices, which in turn meant that they could say that these assets were more valuable than the market gave them credit for. It is as if you owned a stock that trades at $50/share, but which you believe should be worth $75/share, and so your account statement reflected that belief.

This effectively cleaned up bank balance sheets, and this in turn created the faith needed in order to bolster the prices of these assets. In short, these assets went up in value because the banks were allowed to say that they were more valuable.