What to Do About Mark to Market?

Includes: SPY, XLF
by: Barbara Horne

Yet again we have “Headline Hype” clouding what could be an important debate to the consumer and Shareholder.

What to do about Mark-to-Market?

After much reading the solution seems clear. Keep Mark-to-Market as a valuation technique, but remove it from the financial statements. We need as much transparency as possible but we also need stability. In order to determine the health of a company we need to know what the company’s assets are potentially worth in the current market. But, we also need calm in the credit markets. As J.P Morgan’s Brian Donohue said, “when capital is at its peak, banks can lend more. But, as soon as capital declines, the banks have no way to “recall” loans thereby decreasing the risk.”

But, the real and current question is, “Will changing Mark-to-Market help us now without creating future problems?" So, let’s think of it like this, BH Inc. purchased a derivative based on a price increase in CP Shoe’s common stock. At the time of the purchase, CP’s stock was trading at $5.99 per share. Two weeks went by and Beyonce, Britney Spears, Jennifer Aniston and Miley Cyrus were all wearing CP’s hot new shoe and the shoe designer was on Oprah. CP’s common stock goes up. It reaches $49.99 per share. The credit markets are tight so BH Inc. considers selling the derivative in order to have more cash (they want to keep the lights on).

The stock is trading at high volumes. People age 10-45 are buying CP’s shoes.
But, BH Inc. hesitates and doesn’t sell. Another week or so has gone by; Beyonce, Britney, Jennifer and Miley are on to other fashions and Oprah is talking about being green. The shoes have a lot of plastic on them.

So, the stock price drops to $.05 a share.

The credit markets are still tight and BH Inc. needs to raise cash. So, it’s in BH Inc’s best interest to show the derivative on their financial statements at the value that reflects the stock price at the time they purchased it, $5.99 per share.

But, the stock price has dropped dramatically. If they were simply marking the derivative to market it would have to reflect the current stock price, but if they look at the derivative as a Level III asset under FAS 157, they may be able to mark it differently.

BH Inc. brings in The Budget Fashionista’s Kathryn Finney to help develop a model to determine the true value of this asset. With her expertise BH Inc. concludes that the stock price could be $109.99 per share in the future (remember Beyonce, Britney, Jennifer and Miley were wearing the shoes at the same time, so that will go down in Fashionista Herstory). And BH Inc. uses those finding on their financial statements.

Now, if BH Inc’s main asset is the derivative then they may be in trouble if they need to sell it in the current market (remember the stock is trading at $.05 per share). They may not get much for it though it could be worth more in the future. (however, remember all the plastic on the shoe and Oprah said we need to be Green).

But, if BH Inc .has other assets with current potential buyers and they want to hold the derivative until the next vintage fashion craze then they may be in good shape. We never know the value of an asset until it is sold (and even then sometimes there are questions). But we need to know what a company or person owns that they can sell quickly to get enough cash to successfully survive. We need as much transparency as possible especially in a volatile market.

What changes need to be made? With the government aiding in the purchase of toxic assets the challenges institutions face with Mark-to-Market may not currently exist. If consumers are confident stock prices may not have extreme fluctuations and many of the assets that are hard to value will no longer be on the company’s books.

If that’s the case, what’s wrong with the market determining the value of assets? And, why would we need a change in FAS 157 giving institutions more latitude to
Mark-to-Magic assets that may not be that valuable. And, how much will the government pay for these assets, now that there is the possibility of marking them up? Sounds like financial magic with the taxpayer’s wand.

Short of doing a lot of independent research consumers, lenders and shareholders could be at the mercy of the opinion of some of the Institutions that contributed heavily to the current problems.

It is understandable why Berkshire’s Buffett and Congressman Barney Frank question Mark-to-Market and the part it played in the current crisis. On the same token, Buffet makes an excellent point when he says “I hate to give it up”. Consumers and shareholders don’t want to be overwhelmed, but in order to make informed decisions, we need stability and transparency.

It seems there is a lag or a lack of coordination between the markets and the governing bodies. But in some ways that is to be expected. Governing bodies generally require analysis and debate in order to make change while the markets respond quickly to demand.

The difference of opinion is in part due to the difficulty in pricing assets that have no immediate buyers (Level III assets under FAS 157). However, it is not too difficult to price the shoes in the back of the closet that didn’t sell on eBay. Mom was right; all of her clothes from the 60’s and 70’s were what we called vintage in the 90’s. But in the 80’s she had to pay for the gas to drive them to Good Will.

If a company needs cash and there is nothing to sell and no one to borrow from, we have what we have now and rather it is Marked-to-Market, Marked-to-Model or marked some other way matters less; because no one wants to buy the asset when it needs to be sold. But, if we are asking did Mark-to-Market contribute to the current financial crisis, the answer is yes.

But, the question is, what is the best solution now?