Dear People Who Actually Understand Accounting:
Joe Plumber takes out a mortgage on a $1,000,000 dollar house, 20% down, 7% interest. Mortgage company A sells it to him, taking in $200,000 and a note for $800,000. Mortgage co. A packages Joe's mortgage with 10 other similar mortgages, total $8,000,000 face value note @ 7% and that's called a CDO. Bank A floats $7,000,000 of paper @
5%, puts up $1,000,000 of its own money, and buys the $8,000,000 CDO. Mortgage co. A keeps the $2,000,000 down payments, pockets the $8,000,000 from Bank A, and happily goes off and builds more houses or writes more mortgages. (I've ignored fees Mortgage co. A charges Joe, and fees it charges Bank A.)
Bank A now has 7 to 1 leverage, and it's books look like this:
CDO Asset $8,000,000 Cash Decrease (1,000,000)
-------- Note due $7,000,000 Equity $Y-amount Y
The market for CDO's shifts, mark-to-market accounting comes in, and Bank A now has to write down it's CDO to $6,000,000, and shows that $2,000,000 decline in value as a Loss on Investment on its income statement.
Bank A's books now look like this:
CDO Asset $6,000,000 Cash Decrease (1,000,000)
--------- Note due $7,000,000 Equity $Y-amount (2,000,000)
I'm not sure I understand how the reserve requirements play into this
- obviously it has to have some, and their "Cash" has decreased. But it seems to me that if the bank planned to hold the CDO's to maturity, even with a default rate higher than the usual one or two percent, they would not have to write down the value of the CDO's.
If 10% of the homeowners go into default and the bank forecloses at
50% of the face value of $1,000,000 of mortgage, then it writes off $1,000,000 of CDO's, takes $500,000 cash on sale of houses, and its books look like this:
CDO Asset $5,000,000 Cash Decrease (1,000,000) Cash from Sale 500,000
--------- Note due $7,000,000 Equity $Y-amount (2,500,000)
For Bank A to "de-leverage", it has to find a buyer for the CDO Asset. Supposing it found one, and sold $3,000,000 of the CDO's, it would look like this:
CDO Asset $2,000,000 Cash Decrease (1,000,000) Cash Inflow 3,000,000 Cash from Sale 500,000
--------- Note due $7,000,000 Equity $Y-amount (2,500,000)
If Bank A then repaid $2,000,000 of it's paper, it would look like this:
CDO Asset $2,000,000 Cash X Cash from Sale 500,000
--------- Note due $5,000,000 Equity $Y-amount (2,500,000)
And essentially, the bank has shrunk from $7,000,000 to $2,500,000. If leverage were higher than 7 to 1, then the bank goes bankrupt not principally because it has no cash to pay its Accounts Payable, but because it has written down the value of its Assets to such a low level that it essentially has none.
Is the above basically correct?