Mark to Market Accounting: Used with Flexibility, It's a Good Thing

I’ve written on mark-to-market accounting before. Searching my blog, I was surprised to find how many pieces I have written in 2008 on the topic.

• Pandora and the Fair Value Accounting Rules
• Mark-to-Market Accounting Is not the Major Problem
• The Economics of SFAS 157
• Accounting Rules Do Not Affect Cash Flows
• Illiquid Assets Financed by Liquid Liabilities (Or, why were you playing near the cliff?)

So, it’s interesting to me to see the Financial Accounting Standards Board [FASB] interested in continuing with Fair Value accounting, despite all of the criticism. It’s not to say that MTM accounting is perfect — all accounting methods are approximations and are imperfect, but does it convey the best information needed for investors to make reasonable decisions, at an acceptable cost?

If MTM accounting were proposed in the ’80s it would never have been approved. The value of common financial instruments did not usually change much; unless an equity had a public market, revaluations occurred only for reasons of impairment. But derivatives and structured security prices vary considerably, and their prices often vary in a way that approximate valuations can be calculated from the prices of other publicly traded securities.

Now, that many financial companies trade below their net worth is a proof in this environment that investors don’t trust the value of the assets, nor their earning power. Many assets have not been marked down to their fair value.

I will defend SFAS 157, and the other mark-to-market accounting standards, but I won’t defend an application of them that is too rigid. When trades are infrequent, and there are strong reasons why the security deserves a different value than last trade, then let the security be marked to model. It is the best that can be done. But merely that a security is at an unrealized loss for several years should not in itself be a reason to mark the security down, if the management concluded that it was “money good.” (they get their principal back.)

The mark-to-market rules as stated have flexibility in them, aiming for a fair statement of the net worth of the firm. Given the nature of the investments and hedges employed, this is a good thing if done properly and fairly.

Can these rules be used to distort accounting? Of course, in the short run. In the intermediate-term, the errors catch up, and destroy the cheater. In the long run, cash flows determine the value of a business.

So, be wary in the present environment. Just because a financial institution trades below book value does not mean that it is cheap. Much of the cheapness stems from the opaqueness in pricing of unique risks.

The challenge is analyzing what an asset is truly worth, and when that value can be realized. That is the challenge with financials today.

Comments

[Smarty_Pants:]

It seems to me that we've nearly reached the point where application of mark to market in the financial sector is nearly an exercise in futility.

Isn't the goal of mark to market to provide shareholders (or potential shareholders) an honest idea of the current financial state and potential risks that the company's stock or bonds entail?

In theory, this information will be reflected in the share or bond price, changing as updates to the asset values changes, and warning alert shareholders or bondholders to sell when the risk is too highfor their liking.

However, when the gub'mint sloshes buckets of money to the worst offenders against sane corporate practices to "save" the system, then what's the point of marking to market? No matter how far underwater JP Morgan or Goldman Sachs may be or might get, they won't be allowed to fail. Ever. It's a proven fact.

With the passage of TARP the rules have changed. 'Investing' in the financial sector is no longer an option, it has turned into a gambling hall where you are making a short term bet on future price action without regard for underlying fundamentals. Everyone knows that the stock won't go to zero, so why not buy the dips and hope to sell the rallies?

That's just my two cents on "mark to market". Unless and until the big Wall Street firms are held to the same standard as Main Street mom and pop firms are then the reality of mark to market is that it's all for show.

2008 Dec 30 09:34 AM

[dunk01:]

Mark to market, lower of cost or market, these really don't matter--what matters is having a standard that doesn't require a crystal ball or managment estimates of "fair value." Any time there is a standard that requires judgement on the part of the firm, there is going to be trouble. Keep it simple and transparent.

I can't believe the article says "...But merely that a security is at an unrealized loss for several years should not in itself be a reason to mark the security down, if the management concluded that it was “money good.” (they get their principal back.)..."! What better reason to mark it down? The balance sheet and the income statement are snapshots, not forecasts.

2008 Dec 30 09:48 AM

[Randy Miller:]

What if one of my assets was a million barrels of oil? In July of 2007, that oil was worth around $60 million, July of 2008, $140 million, and today it is worth $40 million. Was the $80 million increase a profit? Was the $100 million a loss, because I had to write down the value of that asset?

The value of mortgage backed securities was overstated two years ago, understated today, but the economic value of my house is the same as it was 15 years ago, 10 years ago, and five years ago.

Mark to market is one tool of many, with the objective of preventing fraudulent accounting. Perhaps the problem rests with the people looking at the numbers, people who thought housing in some markets could keep going up 10 percent every year, people who thought commodity prices could keep going up and up, and so on.

So much of valuation is blue sky, based on the psychology of the moment. Willing buyer, willing seller. Reluctant buyer, distressed seller is not a true market for valuation purposes, and I believe the FASB standards factor that in.

We do not need excessive regulation, people filling out an endless pile of forms. WE DO NEED RULES, to keep honest people honest, and to keep dishonest people reluctant to cheat.

2008 Dec 30 10:44 AM

[BerkeleyBob:]

But, in response to the last post, isn't that the vice of the matter? I can accept some flexibility in application of mark to market, but I no longer trust any management to give a straight count. Whatever rule is adopted, I don't believe the lenders have flushed out the toxic and non-performing loans from their balance sheets and don't believe we have reached a bottom in housing prices. Of course, the problems are now far wider than "just" the housing market...

2008 Dec 30 12:46 PM

[petyaczar:]

MArk to market and so called Fair Value Accounting is the ROOT CAUSE of the financial panic we are currently experiencing. MtoM is a ridiculous system that destabilizes the balance sheet of both lenders and borrowers, And in doing so, neither borrowers nor lenders can trust their own creditworthiness wuarter to quarter and year to year.

MtoM ends up creating a self reinforcing feedback loop that exacerbates business cycle and all other fluctuations. Housing goes down, the banks assets get marked down. Assets go down, more reserves are required to avoid a regulators bankruptcy,

Its like having a gas gauge in your car that only occasionally provides an accurate reading of gas in the tank, and every few minutes it changes position to read "EMPTY" even when the tank is full. In the face ofsuch uncertainty, what does the driver do? He pulls in for gas every chance he gets to avoid running out. In the face of such uncertainty what do financial institutions and businesses do? They cut back on lending and available credit. AND THE ECONOMY GRINDS TO A HALT, They hoard cash and build reserves -just in case - instead of putting the money out into the marketplace where it can do some good and create more wealth,

The balance sheet is the financial equivalent of the ballast down in the hull of a boat. It provides stability. The idiots in Congress passed several really idiotic laws and then blame the financial and business community for the ensueing catastrophy (Trillons of dollars and perhaps the truly Great Depression) . enabling the socialist takeover of the capitalist economy by the idiots in Congress.

A solution to our current financial and credit problems? IMO

1)Dump MtoM Drive a permanent stake thru its heart and burn the corpus delicti.
2)Go back to the accounting rules that served us so well since the 1930's depression (the little one) under which companies and their auditors could always decide when to write off nonperorming assets.
3)Reinstitute the "UPTICK RULE" on shorting stock
4)Raise margin requirements to 50% on all commodities futures trading, oil,gas,metals, etc. -same as stocks.
5)Pass a law prohibiting the idiots in Congress and politicians enreally from tinkering with the acounting system. Leave it to FASB and the IRS.

Net result, confidence and stability in the accounting system would be restored, balance sheets would regain stability and the basic premise ASSETS = LIABILITIES + EQUITY would mean something again.

Mr Merkel, you have lost all credibility with me and others with the nonsense you have posted on this topic IMO.

2008 Dec 30 05:59 PM

[petyaczar:]

PS: Saw today where the SEC official position on MARK TO MARKET IS:

"Mark to MARKET is "good" , (it has not caused problems) BUT MtoM MUST BE CHANGED."

ok, if its good and has not caused problems, then ehy must it be changed? Answer = this is SEC political speak - see George Orwell 1984 - translated it means Mark to Market has been a disaster, it cannot be allowed to continue and we will declare victory and then leave it or we will emasculate MtoM to the point that it is no longer meanngful in any way. We are afraid to publicly admit the politicians really screwed this up with Sarbanes Oaxley and the 2004? credit legislation resulting in fair value Fasb rulngs.

Kill it (MtoM) before it kills us. (The American economy)

IMO

2008 Dec 30 06:09 PM

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2008 Dec 31 05:31 AM