The Mark-to-Market Myth

Today the Financial Accounting Standards Board voted – by one vote – to relax accounting standards for certain types of securities, giving banks greater discretion in determining what price to carry them at on their balance sheets. The new rules were sought by the American Bankers Association, and not surprisingly will allow banks to increase their reported profits and strengthen their balance sheets by allowing them to increase the reported values of their toxic assets.This makes no sense, for three reasons.

1. Investors and regulators are not idiots. They know what the accounting rules are. If banks claim they were forced to mark their assets down to “fire-sale” prices, investors can look at the facts themselves and apply any upward corrections they want. Now that banks will be able to mark their assets up to prices based solely on their own models, investors will the downward corrections they want. It’s a little like what happened when companies were forced to account for stock option compensation as expenses; nothing happened to stock prices, because anyone who wanted to could already read the footnotes and do the calculations himself.

However, the situation is not symmetrical, and the change is bad for two reasons. First, fair market value (”mark to market”) has the benefit of being a clear rule that everyone has to conform to. So from the investor’s perspective, you have one fact to go on. The new rule makes asset prices dependent on banks’ internal judgment, and each bank may apply different criteria. So from the investor’s perspective, now you have zero facts to go on. It’s as if auto companies were allowed to replace EPA fuel efficiency estimates with their own estimates using their own tests. We all know the EPA estimates are not realistic, but we can find out exactly how they were obtained and make whatever adjustments we want. If each auto company can use its own criteria, then we have no information at all.

Second, this takes away the bank’s incentive to disclose information. Under the old rule, if a bank had to show market prices but thought they were unfairly low, it would have to show some evidence in order to convince investors of its position. Under the new rule, a bank can simply report the results of its internal models and has no incentive to provide any more information.

So what we get is less information and more uncertainty. That was all reason number one.

2. Between the two options, this is the unsafe choice. Accounting in general is supposed to embody a principle of conservatism. Given plausible optimistic and pessimistic rules, you are supposed to choose the pessimistic one. But think about what happens here. Let’s say the bank has to mark to market, but it turns out the economy recovers and the asset increases in value. In this scenario, the writedown reduced the bank’s capital, so it had to get more. When the asset recovers, the bank is profitable and can buy back the shares it sold.

In the opposite scenario, the bank marks to its own imagination, but in reality the market price was the long-term price. At some point in the future, the bank will have to write down that asset, but it may not have the capital to absorb that writedown, in which case it will fail.

The choice is between the risk of raising too much capital and the risk of not raising enough capital. FASB chose the latter.

3. Mark-to-market is a red herring to begin with. Accounting rules are much more complex than “all assets must be marked to market” and “all assets can be marked to model.” There are different types of assets (Level 1, 2, and 3); different types of impairments to asset values (temporary and other-than-temporary); different accounting impacts (some writedowns on the balance sheet affect income statement profitability, some don’t); and, most importantly, different ways of holding assets. How a bank accounts for an asset depends in part on whether it says that asset is held for trading purposes, is available for sale, or will be held to maturity. Wharton has a high-level discussion of some of these issues, but if you really want to understand them you should read Sections 1.B-D of the SEC’s study of mark-to-market accounting, which I helpfully summarized for you in an earlier post.

The SEC’s conclusions were, in short:

  • Most bank assets are not marked to market to begin with, and half of the ones that are marked to market are the type that don’t affect the income statement.
  • Marking assets to market had only a very small impact on bank capital through September 2008.
  • The bank failures of 2008, including Washington Mutual, were not caused by marking assets to market (increasing loan loss provisions were a bigger culprit). In each case, stock prices started falling before the banks took writedowns, implying that investors already knew something was fishy before the accountants did anything.

I don’t know any of the back-room dealing, but it seems like the banking industry is taking advantage of the confusion to push through a change it wants, because it will make it easier for banks to massage their balance sheets and harder for investors to see what is really going on.

Originally published at the Baseline Scenario and reproduced here with the author’s permission.

5 Responses to "The Mark-to-Market Myth"

  1. Guest   April 2, 2009 at 8:40 pm

    Oh, you’re insolvent? Here, let’s change the rules so you can lie with impunity. Making a profit now? I love hearing that. Say it again!

  2. Guest   April 2, 2009 at 10:08 pm

    Very good points. The new rule gives the banks ample opportunity to fudge the numbers. This will only give more suspicions (rightly so) about a bank’s balance sheet and very definitely the compensation for the executives, based on that balanced sheet. The bankers can always blame their “projections/models” when things go sour. One more reason not to invest in banks – for the foreseeable future.

  3. louisville   April 3, 2009 at 7:42 am

    Excellent blog contains the rules that are followed by the bank are very good.louisville

  4. George Harter   April 3, 2009 at 11:57 pm

    I read your pieces regularly. Question: won’t larger investors avoid bank stocks almost entirely?Fiduciary responsibilities are still a reality outside of Wall St. How could a manager, or trustee explain the purchase of stock from ANY bank?? It was a bargain?? No. Who wants to sued for being a crook AND being stupid as well-that’s embarassing.My hope is that there will be a true equity bloodbath($0.50/share CITI) in the next few months and someone will shut down equity trading of bankshares. Really, I can’t see intelligent buyers even trying to outguess thew bank crooks. It’s so much easier just NOT TO BUY.What happens if CITI gets to trade at 1/8th? Hell, even that may be a bad bet. I DON’T BELIEVE CITI CAN ALLOW A TA SALE TO PROCEED. Geithner’s plan and the FASB will probably shut down a number of TBTF operations.Unexpectedly!!!!.I also do not believev the results of the stress tests will be released quickly. Are there enough folks at the Treasury to fake ALL THE DATA??? SOON???PESTIMIST FROM QUEENS, USA (No, that was not a typo.)

  5. Anonymous   April 20, 2009 at 9:28 am

    Glad I found this article. Just as all the banks are releasing their data and saying “hey we’re profitable” while thinking “thanks to relaxing mark to market!” What a sham! as one poster said earlier, the big investors will avoid the bank stocks because they know, but the little guy will get suckered back in thinking they can get in on the ground floor but in reality he’s got his last bit of cash and is betting it all at the roulette table.