Mark-to-Make Believe


Marking MtM to Market

Proponents of MtM argue that basing values on current prices provides an accurate picture of a firm’s financial position. In particular, it is superior to the alternative – historical cost accounting – where assets and liabilities are valued at the price at the time the transaction was entered into.

Research by Guillaume Plantin, Haresh Sapra and Hyun Song Shin ( see (12 August 2007) Marking to Market: Panacea or Pandora’s Box; Princeton University, working paper) indicates that MtM accounting may, in fact, distort the price of assets. Under historical accounting, if the market value of a bank’s loans increase above historical cost, then there is an incentive for management (who are judged on current profits) to sell the loans. This allows the profit to be realised irrespective of whether the market values the asset accurately. The sale is in the interest of the managers but not necessarily of the shareholders that may be better off if the loans were not sold (especially if the market value is below the “true” economic value of the asset). Under MtM accounting, in theory, the loans do not have to be sold as marking the assets to market value enables the gain to be realised.

In a falling market, this process works perversely resulting in the uneconomic sale of long-term, illiquid assets. If observed market prices are low (below perceived value) due to lack of liquidity then firms may try to sell assets to try to establish higher observed prices. If all firms behave in this way, the resultant selling may drive prices down. This penalises shareholders that would have benefitted from the assets being held as in the absence of default they would receive face value rather than the (lower) market price.

The research highlights that MtM accounting is pro-cyclical and creates volatility of asset values through complex positive and negative feedback loops. Under normal market conditions where asset markets are liquid, MtM accounting works benignly. In volatile markets, where behaviour becomes linked by a common factor such as disclosure required by MtM accounting, co-ordinated actions of market participants can easily lead to sharp movements in asset prices. The process distorts market prices and ultimately the firm’s financial position and value.

The effects of MtM accounting illustrate a fundamental economic principle where eliminating one market imperfection (poor information) magnifies other imperfection (illiquid markets).

In the current crisis, MtM accounting has exacerbated uncertainty. Banks have constantly misjudged values of assets. This uncertainty has been destabilising to market confidence.

The new accounting framework has actually been an impediment to dealing with the problem. In a pre-MtM environment, banks may have responded to the deterioration in asset quality by writing exposures to conservative values to remove uncertainty. This would then have allowed them to re-capitalise to an adequate level to restore confidence. In a MtM environment, there is less flexibility. Firms have been forced to mark assets to unreliable market prices causing them to progressively follow the market down. This has resulted in a “drip feed” of losses and a succession of capital raising measure that have increased uncertainty.

Robert Kaplan, Robert Merton and Scott Richard writing in the Financial Times ( “Disclose the fair value of complex securities” (17 August 2009) Financial Times) asserted that: “Financial assets, even complex pools of assets, trade continuously in markets.” This would have been news to those in the real world that struggle daily to get meaningful prices for many securities and assets.

The learned Professors, without a hint of irony or humour, went on to advocate the use of models for valuation: “Mutual funds in the US now use models, rather than the last traded price, to provide estimates of the fair values of their assets that trade in overseas markets. …  In this way, the funds ensure that their shareholders do not trade at biased net asset values calculated from stale prices. Banks can similarly use models to update the prices that would be paid for various assets. Trading desks in financial institutions have models that allow them to predict prices to within 5 per cent of what would be offered for even their complex asset pools.

Sadly, many of the lessons of the current financial crisis for MtM accounting seem to be lost on some.

Marking Time

The emerging problems of MtM accounting have led to proposals for change. Accountants were stung by the criticism of the standards. One structured finance accountant noted that:  “It’s the market that needs to change, not the accounting.

Officials and commentators have called for the accounting standards to be suspended with firms being allowed to revert to historic values adjusted for expected impairment. It seems that MtM was acceptable when there were “gains”. However, everybody should be allowed to revert to historical or “adjusted” model prices when there were “losses”.

Paul Craig Roberts, a former Reagan administration official, wrote that the mark-to-market rule “is imploding the U.S. financial system by requiring financial institutions to value subprime mortgages at their current market values.” He proposed that financial institutions be allowed to “keep the troubled instruments at book value, or 85-90 percent of book value, until a market forms that can sort out values, and allow financial institutions to write down the subprime mortgages and other troubled instruments over time.”

Steve Forbes from Forbes suggested a 12-month “moratorium” of MtM in “exotic financial instruments (primarily packages of subprime mortgages).” In Forbes’ opinion: “It’s preposterous to try to guess what these new instruments are worth in a time of panic.” Going even further, the publisher and erstwhile presidential candidate, in a Wall Street Journal op-ed piece wrote: “Mark-to-market accounting is the principal reason why our financial system is in a meltdown.

The International Institute of Finance (“IIF”) proposed resorting to historical price to facilitate “stable valuations” that “increase market confidence”. The IIF proposal was dismissed by Goldman Sachs as “Alice in Wonderland” accounting. The IIF, following hasty informal consultations with market participants, central banks, regulators and accountants, clarified their position:

·         MtM accounting will remain as it fosters transparency, discipline and accountability.

·         There is already latitude to use model approaches where observable market inputs are not available.

·         There is a need for clarification of pricing inputs in illiquid markets and the rules may need “refinement”.

·         New “techniques” or allowing “greater flexibility” risks that however well-framed the proposals the intentions of those advocating changes could be “misunderstood by investors at this stage”.

Another alternative approach was suggested by a group of French accountants (Jean-Francois Lepetit, Etienne Boris and Didier Marceau “How to arrive at fair value during a crisis” (28 July 2008) Financial Times). The Gallic thesis was that “market prices [had been] squeezed by a “crisis discount”. They proposed adjusting the valuation using an “upgraded fair value” model for serious crises where the “market” price was measured consistent with their intrinsic values.

The proposal recommended that the accounting regulator in the country concerned would arbitrate that the “crisis discount” was abnormally high. Once this determination was made banks would be able to discontinue mark-to-market measurements of credit assets and switch to a fair value measurement. The “fair value” would be based on a “mark-to-model” approach using parameters set by the regulator. The proposal was reflective of French strengths as identified by Napoleon III: “We do not make reforms in France; we make revolution.

In March 2008, the SEC has clarified the application of SFAS 157. The SEC indicated that it is appropriate to use actual market prices, or observable inputs, even when the market is illiquid, unless those prices are the result of a forced liquidation or distress sale.

Under political pressure, the U.S. SEC and the FASB were forced to further clarify FAS 157 in September 2008. The SEC also conducted a study into mark-to-market accounting – a condition of the Emergency Economic Stabilisation Act passed by the U.S. Congress in October 2008.

The FASB and the IASB altered the accounting standards so that firms were not obligated to use market prices in distressed markets. The changes allowed the reporting firm to use its judgement about whether individual market transactions are forced liquidations or distressed sales. If it determined the market price is not reflective of ‘true’ value or if no observable inputs are available, then the reporting entity could use its own assumptions about future cashflows and risk-adjusted discount rates.

The revised position introduces significant uncertainty about how MtM is to be applied. It is difficult to determine objectively whether prices are “distressed”.

Proponents of the alternatives to MTM seems to have decided that in the final analysis it better to just manipulate the values and pretend that there are no losses using an arbitrary model with assumed inputs in preference to “inconvenient truths” about market prices and the extent of the losses. As Mr. Hazard aka hedge fund manager Jon Shayne sings on You Tube:

“It’s easier to patch and mend and temporize away;

Immediate cost is tough, we favor gradual decay.”

In July 2009, the IASB proposed a further change in MtM principles. Under the approach, reporting firms would need to value a financial investment as a long-term holding or as a trading position. Under the proposed rules, if the investment produces predictable cash flow like a bond, then it would be valued in accounts using an accounting mechanism that smooths out market fluctuations. If the investment’s cash flow is unpredictable, like derivatives, then it would be valued at current market levels.

The proposals were an attempt to resolve the increasingly intense disputes about MtM accounting. The problem was that it now introduces subjectivity in how instruments should be classified.

The amusing thing about the ‘radical’ proposals was that it was a return to exactly what the rules were before the entire MtM system was implemented. Firms valued hold to maturity instruments at book value (accrual accounting) adjusted for impairments and trading instruments at market. Value.

In the words of  Giuseppe di Lampedusa, author of “The Leopard”: “everything must change so that everything can stay the same.

Mark-to-Make Believe

MtM accounting has theoretical advantages. The famed humorist Yogi Berra once opined that: “In theory there is no difference between theory and practice. In practice there is.

MtM and fair value accounting allowed banks to maximize short term returns by recognising profits up-front. Longer term risks of illiquid assets were hidden by the process. When the hidden risks emerged, central banks and regulators were left to solve the problems using public funds. If accounting is a mechanism for communicating financial information, then in the global financial crisis, MtM accounting has been a means for mis-communication.

In a speech in September 2008 to the Institute of Chartered Accountants of Scotland, Sir David Tweedie, head of the IASB, spoke of accountants with “all the backbone of a chocolate éclair.” He spoke of an era of “creeping crumble” when “… auditors [were picked off] by investment bankers, selling a scheme that perhaps was just within the law to a client, persuading two major auditing firms to accept it whereupon it became accepted practice and QCs would tell a third auditor that he could not qualify [the company’s financial report] as the scheme was now part of ‘true and fair’.

Sir David’s outlined his vision of the role: “The accountant is an artist, but he has to portray his subject faithfully…..If the reporting accountant lacks integrity; if raw economic facts are unpalatable and smoothing devices are sought; if he fails to support fellow professionals who have carefully documented their view of the principle, researched the literature and sought advice and made an honest judgment; if regulators demand one answer and one alone, not those within a range; or if the profession constantly seeks answers for all questions – the reporting accountant will paint by numbers and deserve the rule-based standards he has requested. This will be the profession of the search engine, not one of reasoned judgment.”

George Clemenceau, the former French Prime Minister, once noted that: “La guerre! C’est une chose trop grave pour la confier à des militaires.[War is too important a matter to be left to the military.] Accounting may be simply too important to be left to accountants.

© 2009 Satyajit Das All Rights reserved.

Satyajit Das is a risk consultant and author of Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives (2006, FT-Prentice Hall).

2 Responses to "Mark-to-Make Believe"

  1. interested reader   September 18, 2009 at 11:33 am

    Thanks for sharing your insights. But how do you correctly account for the dynamic described below? Obviously, there’s more than just ‘illiquidity’ and ‘lack of confidence’ involved. Can the adverse effects of embedded leverage of certain securities just be ignored in accounting terms?Systemic Risk and the Refinancing Ratchet Effect by Khandani/Lo/Merton:”Abstract:The confluence of three trends in the U.S. residential housing market – rising home prices, declining interest rates, and near-frictionless refinancing opportunities – led to vastly increased systemic risk in the financial system. Individually, each of these trends is benign, but when they occur simultaneously, as they did over the past decade, they impose an unintentional synchronization of homeowner leverage. This synchronization, coupled with the indivisibility of residential real estate that prevents homeowners from deleveraging when property values decline and homeowner equity deteriorates, conspire to create a “ratchet” effect in which homeowner leverage is maintained or increased during good times without the ability to decrease leverage during bad times. If refinancing-facilitated homeowner-equity extraction is sufficiently widespread – as it was during the years leading up to the peak of the U.S. residential real-estate market – the inadvertent coordination of leverage during a market rise implies higher correlation of defaults during a market drop. To measure the systemic impact of this ratchet effect, we simulate the U.S. housing market with and without equity extractions, and estimate the losses absorbed by mortgage lenders by valuing the embedded put-option in non-recourse mortgages. Our simulations generate loss estimates of $1.5 trillion from June 2006 to December 2008 under historical market conditions, compared to simulated losses of $280 billion in the absence of equity extractions.”