So I just figured out another technical detail to why we're having a banking crisis, and I thought I'd share. This is the explanation of how the "capital ratio" requirements and the "mark to market" rules interacted to allow banks to get overstretched and crash dramatically.
Bear with me, this one's complicated!
Banks have a "capital ratio" requirement. (Actually, several, but that's not important right now.)
What is this ratio? Well, banks hold two types of money: depositors' money, and the bank's "own" money -- money they don't have to pay back to depositors. This latter form of money is considered "capital". It might have been raised by selling stock, or issuing bonds (if subordinate to depositors), or by actually making profits; or by holding assets which appreciated (the classic example being the land on which bank branches sit). There are several different definitions with different captial ratios required for each.
The capital ratio is the amount of "capital" divided by the amount of assets. Now, from the point of view of a bank, a loan is an "asset". A mortgage is an asset because you, the homeowner, is going to be paying the bank money. (Similarly, a bank deposit is a "liability" to the bank, because it will have to pay you money eventually.)
Clearly, a bank needs to have at least as much in assets as it does in liabilities, or it will never be able to pay off its depositors. So negative capital indicates a failed bank. A bank could quite safely have zero capital, provided it maintained large reserves. This would mean that it was only lending out a fraction of its deposits, and keeping a pile of them as cash. A theoretical credit union could start out this way until it made some profits (in practice, they usually start out getting a loan from a big bank or something similar).
So banks are required to have capital be at least a certain percentage of assets. (For the most restrictive definition of capital, the current US requirement is 4%.)
However, and this is crucial, for these purposes, "assets" is defined conservatively -- if you expect to have 4% of your mortgage-holders default, you can only count 96% of your loans to them as "assets".
Now for the crisis. Banks wanted to lend more. So they packaged loans into "bonds" (mortage-backed securities), giving all the income and the return of the capital to the bondholder. They then sold the bond for cash, and booked an immediate profit: they lent out $100,000 (for instance) and sold a bond for $120,000 (for instance). The extra $20,000 counted as capital and boosted their capital ratios.
Now, this is totally valid; that bank really did just make $20,000 just for doing the paperwork.
The bonds were purchased by other banks (and other institutions). When banks bought them, they counted them as assets (correct) at their market values (also correct) which started out as the expected return without default (not correct, but reasonable at the time). Note that all that was done was moving risk from one bank to another.
The trouble is that the bank receiving the risk treated them as solid gold, with no risk of default. They counted them as assets at their "full" value, as they would with corporate bonds they owned, not as potentially impaired assets, as they would with loans they made themselves. So they magically made the loan risk "evaporate".
Notice something funny about the capital ratio? Suppose the bank makes $20,000. This is an increase in both assets (hard cash is an asset) and capital (it's the bank's money). A little math: suppose the old ratio was 40,000/1,000,000 = 4%. Then the new ratio is (60,000 /1,020,000)=5.8% or so.
Whee! goes the bank; We can make more loans and take more deposits! That pushes the capital ratio back down to 4%.
Now consider what happens to a bank on the other end, which owns one of these "mortgage-backed securities" and suddenly discovers that it's worth less than it thought. It has to subtract $20,000 in losses from both assets and capital. If the old ratio was 80,000/1,000,000=8%, the new ratio is (60,000/980,000) = 6.1%.
A few more of these "writedowns" and the bank is in violation of the capital ratio laws! It has to raise capital immediately or have its directors arrested!
Now the lack of transparency enters the picture. When a bank issues a loan itself, it is allowed to value it using its best estimates. However, when it buys a mortgage-backed security, it can't, because it doesn't even know who's actually paying the loan! This is the single biggest problem.
And now the "mark-to-market" rules enter the picture. Instead of doing extensive research on the actual underlying loan, as it must if treats the loan as "held to maturity", the bank can value it at whatever the market will bear -- if it declares the "securities" to be "available for sale". This works great for the bank as long as the market is high! When the market dries up, however, they have to mark the securities' value way down, possibly even below the value they'd have if the bank could actually look at the underlying loan and estimate it.
So the banks declared mortgage-backed securities "available for sale" for the purposes of avoiding looking at the underlying mortgages. While the declared value was inflated, they made use of this to lower their available capital (below reasonable levels).
Banks owned a very large number of these MBS, and they all declined in value simultaneously. Or, anyway, some of them started defaulting, and because nobody could tell which ones were based on what mortgages, the market treated them all as declining in value.
And so, because the values had been used to prop up the capital ratio, the declining values put them at risk of violating the capital ratio rules -- or even at risk of having no capital, which would make them insolvent.
Which caused them to need to raise capital immediately. Or declare bankruptcy.
(The Bush/Paulson/Congress plan would not really raise enough capital for them. What a sad joke.)