Understanding the Significance of Mark-to-Market Accounting

“Suspending mark-to-market accounting, in essence, suspends reality.”

Beth Brooke, global vice chair, at Ernst & Young


Misinformation, bad dope, and spin seem to be dominating the current discussion on Mark-to-Market accounting. Let’s see if we cannot simplify the arcane complexity of the accounting rules regarding FASB 157.

Understand why this is even an issue: Many banks, brokers, and funds chose to invest in certain “financial products” that were difficult to value and were at times thinly traded. If you are looking for the underlying cause of why some arcane accounting rule is an issue, this is it.

In my office, we don’t buy our clients beanie babies or Star Wars collectibles or 1964 Ferrari 275GTBs. We purchase stocks and ETFs and bonds and preferreds for them (some clients also own options and commodities). Why? Because we believe — and our clients have insisted upon — the need for instant liquidity. Nothing we have purchased cannot be liquidated on a moments notice. We know what the fair value of these holdings are second by second.

While we may have been tempted by potential greater returns that some of these other products offered, we simply could not justify the risk of owning hard to value, thinly traded, hard to sell items. And, we never had to rely on the models of the individuals who created and sold us these products in the first place, to determine an actual price. If ever a product was rife with self-interested conflicts of interest, this one is it.

That is one of the key elements of the current situation. A decision was made to bypass the broad, deeply traded traditional markets (Equities, Fixed Income, Commodities and Currency) and instead create new markets for new products. No one should be surprised that the net result was a flawed system of garbage paper, with too little room at the exits in case of emergency.

Let’s puts this into some context:

“Accounting is a way of portioning economic results by time periods. It doesn’t affect the cash flows, but tries to allocate economic profits proportional to release from risk. If we were back in an era where the financial instruments were simple, then the old rules would work. But once you introduce derivatives, and securities that are called bonds, but are more akin to equity interests, you need to mark them to market.”

David Merkel

Exactly. Otherwise, you are left with public companies, who have made capital allocation and investment decisions that are hidden from their owners (shareholders) and the investing public.

Now that the garbage is on the books, no one wants to admit the original error of purchasing this class of assets. Its not just that the trade has gone bad, its the original buying decision was so flawed even if the trades were not such giant losers.

Recent actions of corporate titans in the financial sector are essentially an admission that their business model was deeply flawed. No one would invest any capital for a ROI of 50 bps per year. They of course knew this — so they leveraged up that 50 bps 35X or so, creating the false appearance of more attractive returns. This higher risk, potentially higher return paper was part of that misleading process.

Suspending FASB 157 amounts to little more than an attempt to hide this broken business model from investors, regulators and the public. Its not just getting through the next few quarters that matters; Rather, its allowing the market place to appropriately reallocate this capital to where it will serve its investors best. That is what free market capitalism is, including Schumpeter’s creative destruction. (A WSJ OpEd today get this issue precisely wrong).

I have been steadfast over the past 2 years about why I did not want to own any of the financials that held this paper on its books. The key was that we could not figure out what the liabilities were relative to the assets. That is investing 101.

If FASB 157 is suspended, I would advise our clients and the investing public that owning any financials that failed to disclose their holdings accurately were no longer investments — they were pure speculations, with more in common to spinning a roulette wheel than owning Berkshire Hathaway (BRK) or Apple (AAPL) or Google (GOOG). Indeed, I know of no faster way to end up on the DO NOT OWN list than to hide from your shareholders what is on your books.

If investors cannot trust the valuations of what is on a firms books, they simply cannot invest in these firms PERIOD.

There are other alternatives for the institutions that now must deal with this discounted, thinly traded hard to value junk paper. They can sell it for whatever price a the market will bear, they can spin it off into a separate holding company, they can write it down to zero and reap the rewards of mark ups in future quarters.

But suspending the proper accounting of this paper is the refuge of cowards. It reflects a refusal to admit the original error, it hides the mistake, and it misleads shareholders. I find it to be totally unacceptable solution to the current crisis.

As Japan learned, not taking the write downs only delays the day of reckoning. They propped up insolvent banks, and suffered a decade long recession for it. That way disaster lay . . .


Previously: S&P500 ex-Risk ? (November 06, 2007) http://bigpicture.typepad.com/comments/2007/11/sp500-ex-risk.html

Sources: Summary of Statement No. 157 Fair Value Measurements http://www.fasb.org/st/summary/stsum157.shtml

Auditors Resist Effort To Change Mark-to-Market JUDITH BURNS WSJ, SEPTEMBER 30, 2008, 4:29 P.M. ET http://online.wsj.com/article/SB122280147924091325.html

SEC, FASB Resist Calls to Suspend Fair-Value Rules Jesse Westbrook Bloomberg, Sept. 30  2008 http://www.bloomberg.com/apps/news?pid=20601087&sid=agj5r6nhOtpM&

How to Start the Healing Now Fix accounting rules and private money will come. BRIAN WESBURY WSJ, OCTOBER 1, 2008 http://online.wsj.com/article/SB122282734447293049.html

Originally published at The Big Picture and reproduced here with the author’s permission.

15 Responses to "Understanding the Significance of Mark-to-Market Accounting"

  1. Sam Sikes   October 1, 2008 at 9:21 am

    Barry,You act like mark to market rules have been around for two centuries, which is simply not the case. I do not imply that relaxing Mark to Market rules for L3 assets is a silver bullet, but it will at least buy some time until we can set up an exchange to properly value the individual pieces of paper that are in these packages. Do you think it is coincidence that the Rules were mandated last November and then all of the sudden every major bank in the world was instantly in trouble? Also, since when do Beanie Babies and Star Wars Collectibles have a cash flow stream and a maturity date. Your arguement is simply bogus. There is not market for these securities at this time because there is no transparency. Putting a market price on the securities does not add transparency. In fact in an economic crisis like this, I would argue that it decreases transparency, in a very negative way.The fact that congress is considering a bailout is an admission that these securities are not being properly valued in the marketplace. If that is the case, why bring the taxpayers into the problem with a soviet socialist style solution. It is ludicrous, and it creates a self fulfilling prophecy in our credit markets while unnecessarily eroding consumer sentiment.Sam Sikes

    • Pashu   October 1, 2008 at 10:52 am

      SamDerivates haven’t been around for two centuries either. How long can you handle such instruments with old methods?

  2. Anonymous   October 1, 2008 at 9:28 am

    I agree. Getting rid of mark to market accounting would only hide an underlying issue and not solve anything. It would be the equivalent of placing a large gauze pad over a wound that requires extensive surgery.

    • Guest   October 1, 2008 at 7:59 pm

      Barry’s most accurate comment is this: “If investors cannot trust the valuations of what is on a firms books, they simply cannot invest in these firms PERIOD.”If mark-to-market is suspended, any company which doesn’t immediately *advertise* that it is using mark-to-market will die as everyone pulls their assets out.

  3. Guest   October 1, 2008 at 9:55 am

    Is this the same “mark to market” accounting that Enron employed so criminally?I’m not an accountant; I’m the farthest thing from it. I crunch words, not numbers. But if it is the same technique, any sane, honest person should run screaming from the mere idea of its’ use.TG

    • Guest   October 1, 2008 at 8:03 pm

      Enron employed the trick of trading with itself (or rather, between Enron and a shell companies it set up). Then it valued the trade at *market* value on one side and at *non-market* value (as used to be legal) on the other side. But Enron owned both sides. So it was counting a loan to itself at a different value for the “asset” end and the “debt” end, thus generating money on paper without really having any.

  4. Guest   October 1, 2008 at 11:01 am

    Thanks Barry for articulating this point of view.Anger and politics aside, I’m having a lot of trouble with forming an opinion on this topic.Generally, I’m drawn to this hoping to find anything other than having the Govt purchase distressed assets abd accouting for the actions already taken since Countrywide.Assuming $700 billion is even a reliable number, I generally favor insuring the distressed debt (also to spur private $ and find a real market value), and using cash outlays to stem foreclosures. IMHO, if we do not stem foreclosures and falling home prices (16% down YOY) we’re back here again in a few months.As quoted:”Suspending mark-to-market accounting, in essence, suspends reality.”-Beth Brooke, global vice chair, at Ernst & YoungI guess my problem here is that having it in the first place has already suspended reality – and lending.Would it be helpfull to talk about a “mark-to-model” provision along with it’s suspension? It seems to me that Paulson is essentially creating something similar via a reverse auction process. For example, and this is not at all thought through, a 3 year rolling average, or a 2 year historical average + a projected 1 year not-to-exceed projection?

  5. Sam Sikes   October 1, 2008 at 2:56 pm

    Mark to Market assumes that there is a market, and that the market is always rational. In the case of U.S Financial institutions the “market” value of the MBS at 22 cents on the dollar is not rational. To quote John Maynard Keynes, “markets can remain irrational longer than you and I can remain solvent”. We are experiencing this phenomenon first hand. I wouldn’t have such a problem with it if it had been around for 100 years, but it has only been mandated for 11 months. Do you think it is a coincidence that every financial institution on the planet is facing insolvency? Like I said above, by putting together a bailout to the tune of 700 billion dollars, the government is admitting that the market for MBS and other securities is not functioning properly. Why not save the public the anxiety, and just let the banks hold them at a similar value to what the government would pay? These banks are insolvent on paper, not because of a cashflow problem.

    • Rich   October 1, 2008 at 3:46 pm

      After researching this again all day I’m leaning your way Sam

    • Guest   October 1, 2008 at 7:58 pm

      Problem is that these banks are genuinely insolvent, not just on paper.They were listing illiquid, low-value assets as if they were liquid, easily-realizable, high-value assets. Oops. Wrong.There are plenty of small local banks which are not facing insolvency. Because they didn’t pull that kind of crap; they didn’t make bad loans and they didn’t buy bad loans from other people and they didn’t pretend that bad loans were high-value and they didn’t pretend that 30-year loans were liquid assets.

      • Guest   October 3, 2008 at 11:02 am

        why do you keep saying they are “low value” when there is an income stream that continues perform? theoretically, if MBS are really worth 22 cents on the dollar wouldn’t that suggest that 78% of mortgages are in default??

  6. Anonymous   October 1, 2008 at 6:23 pm

    Right On and I Add This:Simply stated, the mark-to-markdown rule states you must assign the value of your bank’s assets according to what the market says they are worth at the time. When the market value of a home drops, the buyer has defaulted on the mortgage, the artificially created demand for homes all across the board has collapsed and years worth of supply has to be worked through, there is no value to the property the bank holds since there are all sellers and no buyers. The value is zero according to the market value. Plain and simple, if you are not willing to make significant concessions to rid yourself of the property in order to keep the defaulting party in the home or find a new buyer (doubtful) at a steep loss, you are required to carry the property at the total loss of mark-to-markdown. Similarly, a third-party will never buy the mortgage which has failed. Banks and investors are not in the business of home ownership and maintenance until the housing supply is exhausted and the mortgage purchaser can recoup the price of the home plus carrying costs on the original mortgage terms acquired by the third-party!Suspension of the mark-to-markdown rules would be a return to the over leveraging of capital that created the mess in the first place. One, it allows the banks to create a subjective value for an asset (the mortgage and underlying price of the physical asset of the home) which the market says is worthless and the bank has failed to find a buyer at any price. Two, this is the same situation which infected Freddie and Fannie since it encouraged them to by theses assets on the faulty assumption the home market would be climbing, the underlying mortgages were payable on reasonable terms, mortgage payments would be made and values maintained in perpetuity. NOT! Finally, the suspension of the accounting rules would be a market ruse which essentially permits the bank to again over leverage by over valuing assets for more cheap Fed money. And, lacking confidence on how any other bank has subjectively valued its unsaleable assets, no bank is going to loan another bank money or issue new loans into a market which has been artificially created.As the L.A. Times reported,. “Accounting purists say a rule change would raise the risk that the banks would resort to fantasy accounting — “mark to make-believe” — that would overstate the value of their assets to investors. The Center for Audit Quality, an advocacy group for the accounting industry, issued a statement Tuesday urging Congress to reject any suspension of mark-to-market rules, saying that would undermine investor confidence by allowing companies “to mask the actual value of financial assets at a given point in time.”No one can say the investment banks, which effectively started the dominos tumbling, were not part of and fueling the mortgage problem. And yet, it was in 2004 that the same investment banks petitioned an obtained SEC approval to allow them special status to leverage their assets up to 40 times compared to the previous 12 times applicable to themselves and banks. This was known as the “Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities” and which allowed investment banks, including Goldman Sachs being run by Paulson, to subjectively determine “net capital to include securities for which there is no ready market”. Now, the proposal is to allow every financial institution to make its own determination of market value! Talk about not learning from a mistake.As an relevant aside, everyone should be calling for Paulson to step aside from participation in the execution of this plan – whatever the final terms. In February 2006, at the latest, Paulson’s Goldman Sachs Group began using an internal and copyrighted Powerpoint presentation entitled “A Primer on the Sub-Prime Market” by the “Goldman Sachs Structured Products Strategy” division. That document indicates how to sell the securities and then states, “Given the belief that house prices in the U.S. are too high, there are several trades that can be executed to short house prices”. In the Spring, Goldman Sachs thereafter sold mortgages tronches, totaling $496 million, to the unwitting clients who lost an estimated 300 million. Goldman however handsomely profited again on the failure of these securities by shorting the market and sales!! See, Sloan article in Washington Post. Instead, notables like PIMCO Investment founder Gross, and David Einhorn of Greenlight Capital, are knowledgeable about the debacle and the house of cards on which it was built. In fact, Mr. Gross stated on CNBC he would run the program for free!A more appropriate response to the “mark-to-markdown” rule would be allow a limited waiver of the rule for any mortgage renegotiated with the “primary residence” homebuyer which puts them back in the foreclosed or abandoned home. As a result, the home would be sold, the home occupied, a simplified mortgage based upon actual ability to pay in place, renegotiation taking place at the local level with knowledge of local markets, federal intervention avoided, excess supply removed from the market, a bottom up approach utilized and liquidity enhanced. The changed mortgage could the be valued at the new market as reasonably estimated by the bank. The “Plan” would then be buying assets which tend to re-establish the fair market value and others are more likely to step in when the toxicity is removed. Note the proposed rule waiver would only be applicable to a primary residence. Sorry, no help for flippers and speculators.For any one interested in an examination of the greed in sub-prime mortgage the NY Fed noted the overreaching of the effects of the usurious terms ” begs the question why such a loan was made in the first place.” Please search, read and digest: “Understanding the Securitization of Subprime Mortgage Credit”, Staff Report No, 318, by the Federal Reserve Bank of New York, March 2008Sorry, we were so rude as to inject a comment on the issue of “mark to market” and its application.Lance Free & Jay DeeLance Free Consulting

    • Guest   October 3, 2008 at 11:10 am

      Your argument, while thoughtful, is not correct. You are talking about a mortgage in default. The whole point is that performing mortgages are being written down to zero (or close). If MBS are really worth 22 cents on the dollar, wouldn’t that suggest 78% of mortgages are in default? But they are not, default rates are closer to 8-9%. While this is high (more than double historic default rates), should the entire global economy be collapsing because default rates have gone from 3-4% to 8-9%. MTM is too extreme and shouldn’t be applied across the board.

  7. Guest   October 1, 2008 at 7:55 pm

    What nobody seems to have noticed is that, last time I checked, banks are *not* required to mark-to-market!That’s right!They’re only required to mark-to-market assets which are held “available for sale”!If they hold assets to maturity, *not* available for sale, they do *not* have to mark them to market!It seems that the problem is this: if they count them as totally illiquid assets this way, then they turn out not to have enough liquid assets to legally run a bank. Banks are supposed to have a certain amount of liquid assets to pay depositors and so forth. And they don’t. Well, they’re getting the bank runs they deserve now.

  8. Andy   October 8, 2008 at 3:39 pm

    Good article and I think M-2-M accounting is fine for most assets, but as I discussed, recently mark to market accouting in illiquid markets can really magnfiy the problems as we are seeing today.