Maggie's Farm

You have described an element of mark-to-market accounting under FAS 157, which is (i) market based and has observable data points (ii) based on the exit price versus an entry price, (iii) based upon management assumptions in thin markets when no relevant market data is available and can marked to model in certain circumstances.

If your neighbor sold his home in a distressed process, FAS 157 would require you to mark your comparable home to market accordingly. Your net worth would be less.

Does this mean that you would realize a similar amount under an orderly, non-distressed process? Most likely no.

Now apply the concept to banks, which have been forced to write-down various assets based on FAS 157. Capital is destroyed and the capacity to lend is impaired. In fact, banks shrink assets (such as loans) in an effort to keep adequate capital ratios.

Why would a bank make a loan, if it immediately had to write the loan down? It won't.

The write-down doesn't necessarily mean that the loan is not money good. Nevertheless, bank capital is impaired.

This one of the dynamics at work today and continues to contribute to the financial crisis.