First, a little background on how mortgages work. The bank loans someone money to buy a home at 8% interest. The bank then sells bonds that are backed by the value of the home and pay 6.5% interest. The bank makes money on the interest rate spread. For the bank, the mortgage is an asset they hold. The bonds are liabilities they have to make payments against. Now, the focus can turn to the mark-to-market rule and it's role in this.
Mark-to-market means that each quarter banks must value assets to current market value. This rule is bad even when the markets are liquid. It allows banks to inflate balance sheets when interest rates are falling. If a bank owns a $100k mortgage that pays 8%, that mortgage increases in value when mortgage rates fall to 7%. While the fed was cutting interest rates, it was inflating the balance sheets of banks. This made banks appear more capitalized than they really were which led to more lending.
Interest rates go in cycles. The Fed had to start raising interest rates to combat inflation. Now an increase in interest rates has the opposite affect on bank assets. The $100k mortgage at 7% becomes worth less when rates go up to 8%. Banks were becoming less capitalized and had to scale back lending.
Then things really went south. The economy started to slow, home prices stalled, and foreclosures started to rise. Suddenly, investors started to realize the mortgage backed securities (MBS) they were buying weren't really backed by much. Then the worst thing possible happened. The market froze and the MBS became illiquid. This is where mark-to-market killed the asset sheet of banks.
Banks were forced to write down BILLIONS in paper losses. They had to mark their mortgage assets to the market. The values of some were being written down to 15-25% of the original loan value. Suddenly, the banks did not have enough assets to cover their liabilities and continue operations. The fed stepped in giving them BILLIONS in loans, bailouts, etc.
The real secret is these banks were NOT in financial trouble. Washington Mutual was forced out of business. Their last quarter they had over $3B in positive cash flow. Does that sound like a business that needs rescued? Does it sound like a business that should be forced out? Fundamentally, their business model was still working. They had enough customers still making loan payments that they could pay their debt obligations and have money left. WaMu's real problem was mark-to-market accounting made them write down BILLIONS of dollars of assets. After that, they didn't have sufficient assets to maintain operations and continue lending money to customers. Yes, an arbitrary accounting rule that's ~2 years old has forced banks that are cash flow positive out of business.
Here we are today. The government has poured TRILLIONS into fixing this problem and it's not fixed. Why is that? There's still no market for MBS or other bank assets. The second a bank loans out $100k to a customer they have to write down the value of their asset. Why would any business take an asset of $100k cash, then loan it out when the loan is worth $25k according to mark-to-market? Loaning money will destroy the asset sheet of banks until there is a market for the assets or mark-to-market is repealed.
Now we can't just repeal mark-to-market and let banks do whatever they want. We know where that leads. A fairer approach would be to value assets based on the percentage of defaults. Banks could use a 90-day trailing average. This would mean that if last quarter 8% of loans defaulted, then the bank must write down it's portfolio of loan assets by 8%. The bank would use that adjusted value to determine if it meets capitalization requirements. This would allow banks to function normally while providing visibility to default rates.
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