Mark to Market Frustration

While spending and investing billions of dollars-or is it trillions?-trying to heal the sick credit markets, the government continues, inexplicably, to ignore the low-hanging free fruit of suspending or modifying mark to market accounting. We are hoisting ourselves on our own petard by adhering strictly to accounting rules that unnecessarily threaten to put thousands of viable financial institutions out of business.

Financial institutions will fail, not because of actual losses, but because of rules requiring drastic write downs of securities that could be held to recovery or maturity because the market for them is temporarily frozen. On mortgage backed securities, for example, even those containing mostly performing and cash-flowing underlying mortgages have to be treated as a virtual total loss because the market for them is not functioning. The loss isn't prorated; it's total. Ironically, if the individual mortgages contained in the security were owned separately, the write down would be minimal.

So what?  The so what is that an institution's capital must be reduced dollar for dollar with the write downs.  As capital approaches zero, the regulator or insurer will close them to protect the insurance fund. What the "let them fail" crowd doesn't seem to get is that this is all unnecessary, is based on hypothetical losses rather than real losses, and does not result from wrongdoing or bad management.

I've been harping on this for months.  I do see more people coming to realize the implications of this self-imposed financial suicide, but nobody in charge seems to be listening, although I did hear Treasury Secretary Paulson refer to mark to market as pro-cyclical in a recent speech.

I don't know why he doesn't follow through and do something about it.

Whenever the case is made, someone always brings up the presumed negative effect on transparency as a deal killer. Since I'm not an expert on accounting, my response has been that surely there must be a way to fix the problem and preserve transparency. That should be easier because it isn't the marking to market that's so deadly, but its translation dollar for dollar into a capital reduction.

One approach that has been suggested by representatives of PricewaterhouseCoopers – not known as Cowboy Accountants – would involve continuing the markdowns, but have them count against current income (and capital) only the portion to be lasting and attributable to credit impairment. The portion of the markdown related to illiquidity could be counted in another account-one that would not immediately impact regulatory capital.

Splitting impaired assets into a credit-loss component and a liquidity/market component could still allow the credit losses to impact regulatory capital, but the liquidity/market component could run through a different account that would still affect equity but not regulatory capital. Investors would still have their transparency, but exaggerated hypothetical losses would not bring the institution down.

There must be many variations on such a theme, and the accountants are best suited to find them or invent them. They should serve their country by helping to save its financial institutions rather than watching the calamity of crucifying the financial system on the cross of mark to market accounting.

Comments (5)

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  1. Jay says:

    The fair value proponents have the support of accountants and the public. Why ? Because mark to market sounds right.

    But here is an argument I have been using and it stops the debate in its tracks.

    Year 2000. Tech Stock. Trading at $100. No earnings. Negative cash flow. Investor margins 50% for $50 worth of margin. Make sense ?

    Year 2005. Las Vegas real esate. Sales price $550k. Yield on rental 1%. Value based on cash flow $300k.

    These are examples of de facto mark to market ‘type’ scenarios on the ‘other side of the trade’. Not only is mark to market accounting making the bust worst than it should be, it is made the bubble.

    Can any accountant justify lending 50% on a worthless stock or real estate with no money down when the replacement value is much lower. Only someone who believes lending should be based purely on ‘market’ prices and not take into account a cash flow model to determine what an asset ‘should’ be priced at.

  2. I’m not an accountant, I’m an engineer, but I’ve recently started working on Business Intelligence software so I’m getting familiar with how business types like to get information presented and processed (above and beyond the standardized GAAP stuff needed for legal compliance) and coming up with novel ideas to bounce by them. So a way to ward against m2m’s pitfalls when a market is near-frozen is to compute a time-decaying moving average *weighed by volume of transactions*, so times in which there are basically no transactions, or few and far between, get properly discounted (unfortunately, if adopted acritically, this would actually make the pro-cyclical aspects of m2m even worse at the TOP of a frothy bubble, when nobody’s complaining about things except the usual suspects such as Roubini or Taleb… so, some other corrective mechanisms are needed at that time of the cycle!).

    Jay, cash flow is indeed a great measure in many cases, but not all that useful when you’re trying to evaluate goods that are owned and used by the same corporation — e.g. office buildings; financial wizards _try_ (by “imputing rents” to business units of the corp that use the buildings), but it never really works well as the “cash” flowing is all virtual… and trying to use as comparables the rents paid in similar or nearby offices doesn’t work well either because different corps end up paying such different rates (“it’s complicated”…;-).

  3. richard M says:

    Tying asset valuation to the vicissitudes of the market makes as much sense as “marking” tonnage, the revenue-generating capacity of cargo-carriers, to flood and ebb tides. Wall Street can stop shooting itself in the foot by dropping accepted accounting practice’s “mark to market” approach to asset valuation, and replacing (or at least supplementing) it with a basis that is geared to MSL or some such equivalent measure of change in an asset’s income-generating capacity. The lethal flaw in marking assets to market lies in ignoring the price-history of the asset from which a normal market price P0 could have been projected. Such projection will have accounted for the imprint that past market conditions, including previous boom n’ bust cycles, will have left on P0, but it does not and cannot anticipated current vagaries of either Nature or Man. These unexpected “extraordinary (price) movements” can be graduated at levels of price-range between P and P0 and labeled MSL, for Market Sentiment Levels, where P – P0 = MSL. But, how will this have solved the problem? By way of illustration, let’s assume home prices (by a factor of 10) follow the Dow. A $126,000 home was mortgaged to some bank six months ago when the Dow was 12,594 on 05/28/08 (see PMC_0 at TDN 30 in Chart SMP_2.3_1111. In normal times, without unanticipated “extraordinary (price) movements” in the market (when Dow would project to 11,146: PMC_0 at TDN 154 in Chart), the house would fetch a market price $111,460 (P), equal to P0 the projected price derived from its expected rental income stream, with MSL (= P – P0) = 0. Unfortunately, since becoming a part of Lehman Bros’ toxic asset heap, the house is now valued at $77,170 (P) on 11/20/08, the day when DJIA projected for 7,717 actually hit bottom at 7,552 (PMC at TDN 154 in Chart). From initially MSL = 0, the house’s MSL rating is now -14 (apprx = 7,717 – 11,146 divided by 248 per MSL step) representing 31% devaluation along with the Dow, yet its income-generating capacity (and real MSL = 0 at TDN 30 & TDN 154) has not changed. Using the above formula P – P0 = MSL avoids marking the house to market at $77,170 on 11/20/08 as Dow hit its multi-year low, resulting in a 31% reduction in market value corresponding to MSL = -14. The property on that day would instead be assigned a MSL rating of, say, -4 (to provide for the renter perhaps needing to take a haircut on his salary in this bad economy), and valued at $101,460 = $111,460 less $10,000 (where $111,460 = P0, the market price projected from the asset’s price-history which is correlated to its rental income stream, and $10,000 = 4*$248*10).

  4. richard M says:

    By golly, Dr McTeer, based on what you have written on Mark to Market and Dave Spicer's "Economic Tailspin: The Disaster Aboard FAS 157", you and Dave should start a class-action lawsuit against all who had a hand in creating this global financial disaster, on the ground that m2m is both irrational and unnecessary (because a rational and mathematically derived alternative is available). In my last comment on your blog, I have shown an alternative basis for evaluating MBSs based on their current value (P0) as projected from their price-history. The latter rationally reflects the valuation of the earning stream of the MBSs (as expressed in their price)over a time period in the past which would have included boom and bust market conditions. The above valuation projection method is novel and awaits publication, but I am prepared to release it pro bono.

  5. richard M says:

    Dr McTeer The last paragraph of both your “Mark to Market Frustration” and Mr David Spicer’s “Economic Tailspin: The Disaster Aboard FAS 157” should be reprinted and circulated to every congressman and senator, every journalist that speaks for Wall Street, and to all the populist media that lookout for Main Street. Long ago, with the “stroke of a pen” and “crucifying … on the cross”, one underling dashed Man’s hope for access to a better next world; 2 millenniums later, another is well ahead in denying billions of their dream of a more financially secured this world. With apologies to the Bard, where is the Antony that “would ruffle up your spirits, and put a tongue in every wound of [Main Street], that should move the stones of [the world] to rise and mutiny”?