Why Mark to Market?

Here's an interview I did for Bloomberg on Sept. 15. Click here.  

Below is a piece I did for forbes.com.  You can access it by clicking here.

Forbes.com

Commentary
Why Mark To Market?
Bob McTeer 09.15.08, 12:50 PM ET

I was afraid of accounting in school; I still am. Back then, I feared it would wreck my grade point average; today, I fear it will wreck our financial system.

It has come uncoupled from common sense. It's ceased being a tool for business and has become its master–and not a benevolent master at that. It's causing unnecessary failures of basically healthy businesses and contributing to the downward spiral of our credit markets.

I refer primarily to mark to market accounting, which forces firms to revalue their assets to current market values even when the market is frozen or dysfunctional and even when the assets could be held to maturity and redeemed at face value.

If a bank loan goes into default, it makes sense to write it off the books. If a borrower has missed several payments, it makes sense to set aside a provision for the likely loss. But if a security trades lower because market interest rates have risen or because of problems in the market itself, requiring an immediate write-down is unduly harsh, because capital is reduced by the same amount.

Because capital is usually, and legitimately, a small percentage of assets, capital can easily go to zero and a perfectly sound institution can be declared insolvent and taken over by its insurer or some other government agencies.

"Prompt corrective action," also adopted as one the "reforms" of the early 1990s, makes the matter worse by allowing the authorities to pull the trigger before capital reaches zero. Its purpose is to reduce the cost of "resolving" (read "taking over") troubled institutions, but what it amounts to is shooting the sick and wounded to expedite the burial. Efficiency and cost effectiveness trumps fairness.

Were Fannie Mae and Freddie Mac insolvent when the government took them over? Did their capital reach zero? I don't know, but I doubt it. It all depends on how much capital was reduced by marking assets to market. People will say management had an incentive to write their assets down to little. Granted, but might the government have had an incentive to mark them down too much to justify a "conservatorship," which was apparently its preferred solution?

As I write this, there is much discussion of private sector purchases of weakened financial institutions and the disincentive provided by the prospect of triggering mark-downs by doing so. The purchasee already has low marks, which will be inherited by the purchaser, in addition to which the ratings agencies are likely to downgrade the new entity and trigger other negative events.

Isn't it ironic, and galling, that the rating agencies helped create our current problems by looking through rose-colored glasses during the good times, and now they are exacerbating it by looking through their dark shades.

Mark to market rules and strict ratings may be appropriate (though unfair) in the good times as a means of preparing institutions for the bad times. That doesn't mean they should be rigidly applied or even tightened up during the bad times. Hard exercise may boost your immune system to help stave off disease. Hard exercise after the onset of the disease may not be such a good idea.

Critics of some mild regulatory forbearance during this most serious of crises since the Great Depression will no doubt cite transparency as essential, but the two can go together. I'm not advocating hiding temporarily impaired assets. They can remain on the balance sheet with a footnote explaining the intent to hold to maturity.

It is time for common sense to come before accounting purity and cut our losses. It's one thing to become a victim of a bad loan or a bad economy. It's quite another thing to become a victim of unnecessarily strict accounting rules.

Bob McTeer is a distinguished fellow at the National Center for Policy Analysis and former president of the Federal Reserve Bank of Dallas.

Comments (14)

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  1. Sam Timpano says:

    Bob;

    You are so very right and on target with this mark to market issue. Is there any way in which this can be pressed on Paulson and the rest of the policy makers? If so, it should be done in order to remove this incredible death spiral this one piece of horrific legislation/regulation is creating.

    Please try and make your voice heard, it is the way to stem this unrelenting tide.

    Regards,

    Sam

  2. JKH says:

    Marked to market accounting confuses asset valuation at the firm and shareholder levels. A more balanced approach would disclose asset values at the firm level without incorporating them into the income statement, leaving the market to judge the appropriate trade-off between disclosed asset values and accounting income in valuing the firm’s stock.

  3. Tom says:

    Interesting pointing out the reasons for failure to be related to a simple thing as an accounting policy, but is the problem not deeper where cooperations are engaging in business practice which sees excessive leverage, inefficiency and poor management of shareholder resources?

    Also, most companies publish financials quarterly – when does the auditors look at these financials and certify them. I guess the real question here is – ‘are private corporations too large for private individuals to manage?’

    Who protects the investors and their investments when corporations make poor or bad decisions?

  4. MWM says:

    I have now listened to several prominent commentators including, Steve Forbes, Larry Kudlow, Bill Issac (a former FDIC Chair), Brian Westbury, and Dr. McTeer call for the suspension of the “mark-to-market” accounting rule. One must ask why this issue isn’t gaining traction with Congress and the Administration. I have not heard one counter argument, why?

  5. Rob McMillin says:

    MWM — because you’re not listening?

  6. ecoshift says:

    re: a footnote explaining the intent to hold to maturity

    I’d say marking to maturity should require a commitment, and the wherewithal, to hold to maturity.

    If an asset can’t be sold at the value marked on the balance sheet, how can it be used to balance liabilities in the event of a default by the owner of that asset? It can’t. It’s a fictitious value. A balance sheet is a snapshot of your net worth at a given point in time. If your assets are impaired at that point in time your balance sheet become fiction.

  7. [...] For months, I’ve advocated a simple measure that would make a big difference — the suspension or alteration of mark-to-market accounting rules. My latest effort was an article in Forbes.com reproduced on my blog. [...]

  8. MAS says:

    MWM, let me be your devil’s advocate. The most basic counter argument would be that what is really hurting investor confidence is our inability to trust financial statements. Under the deregulation (Basel II for example) that our country has undergone recently, banks have been able to leverage excessively and hide it. Leverage has an exponenetial effect on the growth (and demise) of a company. High (and hidden) leverage heated the markets fairly well when things were going good, but now that we have hit a downturn, those same policies are starting to hurt. Banks were allowed to hide their poor investments, and because they cannot trust each other’s balance sheets, they refuse to lend money to each other.
    Dr. McTeer is advocating a position that allows banks to bury their poor choices in footnotes to make their positions seem more sound. Unfortunately, this will only delay and eventually exacerbate the problem. His plan relies on people to not understand that every bank’s balance sheet is no longer reliable.
    Deregulation like this might work in speeding up an economy that is already moving along at a good clip, but using it now in a time of financial uncertainty doesn’t even make sense.

  9. Dennis says:

    This isn’t a simple issue and ecoshift is correct. As I understand it, CDOs are not simply a portfolio of mortgages but securities that were intended to be traded. A “product” intended to turn illiquid long term assets into short term securities. If they’re offset by short term funding on the books of highly leveraged investment banks and similar holders, there’s a definite mismatch. This is so similar to the ’80s S&L crisis where the newly deregulated thrifts got into businesses they didn’t understand & funded long term loans w/short term deposits. I don’t think Merrill understood what they were buying & probably didn’t understand what they sold at 22 cents on the $

  10. JuanTwoThree says:

    Those reading this blog, should refer to the many counter-arguments posted in the NYT piece. It seems the average NYT reader can easily poke holes in the failed financial logic of “I know: lets use better blindfolds”.

    When we all know assets and liabilities are not marked-to-market is it not logical to reduce our counterparty risk, cash-out investments at the optimistic prices, and hoard cash? How is that a step forward?

    I would suggest that markets in all of these instruments be promoted. Sometimes it may be necessary that the FED or Treasury sponsor them directly. It may be scary at first but, after investors have seen they have the option to sell, there is a final buyer, they can get back to comparing risk rewards.

    This will help us stop worrying about the return OF our money and back to the return ON our money.

  11. Denny says:

    Accounting is there to account for the vaulted, internal, financial complexities on a simple public piece of paper. Valuations are all arbitrary and so ruled by accounting rules that everyone in the game accepts. Securities are valued on a financial statement’s as-of date, by same-date public market records. Corporate managers who bought risky securities either didn’t do their homework in terms of the structure and content of these stocks, or they didn’t set up enough reserve-for-loss appropriate to the stock’s risk, or both. Now corporations must take the mark down required by auditors, so the corporation’s public financial statement is accurate to the public valuation of the stock. Embarrassing yet, wrong, no. Corporations can use footnotes to mention the now-off-balance-sheet assets held for later recoveries. The corporation might also mention what it is doing to collect or restore value to these securities, other than dumping on the taxpayer.

  12. Dave says:

    Mr. McTeer: You’re right on. The misapplication of Mark-to-market valuation (FAS-157) has turned a $300B real estate problem into potentially a $12T mortgage problem by decoupling the security from the underlying assets. I have put together a YouTube video on how this came about: http://tinyurl.com/solve-it. So today we see that the $700B we voted to be used to purchase MBSs is instead being used to purchase controlling interest in banks who in turn are using the money to purchase the banks that have not been so fortunate to be in on the ‘gift’ for pennies on the dollar…when they were supposed to be using the money to create new loans. Ultimately, people will realize that an MBS that is paying a significant amount of interest can’t be worth zero! Then we will do as you suggest and correct the problem and the banks that received the ‘gift’ will have assets that magically appreciate by a factor of 20! If that happens, I hope the American people don’t figure out how they’ve been fleeced. I can think of two reasons for not just rolling back Mark to market to begin with: ego and lawsuits… I suspect mostly the latter.

  13. richard maher says:

    Dr McTeer 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 my website). 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.

  14. richard M says:

    MAS is right about the odious subject of leverage & footnotes, but he's tarred and feathered the wrong target, which is FASB. Maligning Dr. McTeer with allowing "… banks to bury their poor choices in footnotes to make their positions seem more sound" has the ring of a criminal charge. Without advancing a transparent rational alternative asset valuation method, which conceptually is challenge-proof, to replace m2m is about the only fault I can find with Dr. McTeer's postion. In "Mark to Market Frustration", he is winsomely modest in saying he's no expert in accounting, but in so doing, he has misplaced faith in a profession not known for gaining public trust by opening its accepted or recommended practices to challenges by falsification (re. Popper, Karl, on validity test of propositions); like using footnotes when you can't rationally quantify, and acquiescing to leveraging while blind to that two-edged sword. You're hearing this from an once-aspiring mid-level auditor (for 2 years) nearly 60 years back, before he was claimed by a less demanding engineering career, so I have no axe to grind against the accounting profession.