EU Eases Mark-to-Market Rules; What's the U.S. Waiting For?

Includes: DIA, FXE, IEV, QQQ, SPY
by: Vernon Hill

The European Union has accepted the International Accounting Standards Board’s proposed easing of its version of mark-to-market accounting rules. Good for the EU.  The U.S. should follow.

As I mentioned here Wednesday, mark-to-market accounting forces long-term investors to act like speculators, by insisting they pay too much attention to near-term changes in the prices of their financial assets. M-T-M, recall, requires companies to mark their financial assets to market each quarter, and run the price changes through their P&L. For assets that trade on liquid markets, that makes sense. But if the asset is illiquid, or trades in a market that occasionally (like now) freezes up, “market” prices can often be totally unrelated to the asset’s actual intrinsic value. In cases like that, all MTM accounting does is blow up a company’s balance sheet for no reason.

So the EU is right to give European companies relief. Why shouldn’t the U.S. do the same thing? Third-quarter earnings season is underway, and the latest round of asset writedowns has begun. But the bulk of those marks won’t have anything to do permanent impairment of assets. Rather, they’ll simply reflect the massive spread-widening going on in the financial markets as part of the financial crisis.

Even so, the writeoffs will kick off a familiar, highly destructive cycle: balance sheets will become impaired, credit ratings will be downgraded, and new capital will have to be raised on onerous terms. And heaven help the companies that can’t raise new capital.

All of this could occur, I remind you, because of an accounting rule. The best thing that can happen would be for mark-to-market accounting to be seriously modified. The Europeans have started to do that. The U.S. should do the same.