Understanding the Significance of Mark-to-Market Accounting
"Suspending mark-to-market accounting, in essence, suspends reality."
-Beth Brooke, global vice chair, at Ernst & Young
>
Misinformation, bad dope, and spin seem to be dominating the current discussion on Mark-to-Market accounting. Let's see if we cannot simplify the arcane complexity of the accounting rules regarding FASB 157.
Understand why this is even an issue: Many banks, brokers, and funds chose to invest in certain "financial products" that were difficult to value and were at times thinly traded. If you are looking for the underlying cause of why some arcane accounting rule is an issue, this is it.
In my office, we don't buy our clients beanie babies or Star Wars collectibles or 1964 Ferrari 275GTBs. We purchase stocks and ETFs and bonds and preferreds for them (some clients also own options and commodities). Why? Because we believe -- and our clients have insisted upon -- the need for instant liquidity. Nothing we have purchased cannot be liquidated on a moments notice. We know what the fair value of these holdings are second by second.
While we may have been tempted by potential greater returns that some of these other products offered, we simply could not justify the risk of owning hard to value, thinly traded, hard to sell items. And, we never had to rely on the models of the individuals who created and sold us these products in the first place, to determine an actual price. If ever a product was rife with self-interested conflicts of interest, this one is it.
That is one of the key elements of the current situation. A decision was made to bypass the broad, deeply traded traditional markets (Equities, Fixed Income, Commodities and Currency) and instead create new markets for new products. No one should be surprised that the net result was a flawed system of garbage paper, with too little room at the exits in case of emergency.
Let's puts this into some context:
"Accounting is a way of portioning economic results by time periods. It doesn’t affect the cash flows, but tries to allocate economic profits proportional to release from risk. If we were back in an era where the financial instruments were simple, then the old rules would work. But once you introduce derivatives, and securities that are called bonds, but are more akin to equity interests, you need to mark them to market."
Exactly. Otherwise, you are left with public companies, who have made capital allocation and investment decisions that are hidden from their owners (shareholders) and the investing public.
Now that the garbage is on the books, no one wants to admit the original error of purchasing this class of assets. Its not just that the trade has gone bad, its the original buying decision was so flawed even if the trades were not such giant losers.
Recent actions of corporate titans in the financial sector are essentially an admission that their business model was deeply flawed. No one would invest any capital for a ROI of 50 bps per year. They of course knew this -- so they leveraged up that 50 bps 35X or so, creating the false appearance of more attractive returns. This higher risk, potentially higher return paper was part of that misleading process.
Suspending FASB 157 amounts to little more than an attempt to hide this broken business model from investors, regulators and the public. Its not just getting through the next few quarters that matters; Rather, its allowing the market place to appropriately reallocate this capital to where it will serve its investors best. That is what free market capitalism is, including Schumpeter's creative destruction. (A WSJ OpEd today get this issue precisely wrong).
I have been steadfast over the past 2 years about why I did not want to own any of the financials that held this paper on its books. The key was that we could not figure out what the liabilities were relative to the assets. That is investing 101.
If FASB 157 is suspended, I would advise our clients and the investing public that owning any financials that failed to disclose their holdings accurately were no longer investments -- they were pure speculations, with more in common to spinning a roulette wheel than owning Berkshire Hathaway (BRK) or Apple (AAPL) or Google (GOOG). Indeed, I know of no faster way to end up on the DO NOT OWN list than to hide from your shareholders what is on your books.
If investors cannot trust the valuations of what is on a firms books, they simply cannot invest in these firms PERIOD.
There are other alternatives for the institutions that now must deal with this discounted, thinly traded hard to value junk paper. They can sell it for whatever price a the market will bear, they can spin it off into a separate holding company, they can write it down to zero and reap the rewards of mark ups in future quarters.
But suspending the proper accounting of this paper is the refuge of cowards. It reflects a refusal to admit the original error, it hides the mistake, and it misleads shareholders. I find it to be totally unacceptable solution to the current crisis.
As Japan learned, not taking the write downs only delays the day of reckoning. They propped up insolvent banks, and suffered a decade long recession for it. That way disaster lay . . .
>
Previously:
S&P500 ex-Risk ? (November 06, 2007)
http://bigpicture.typepad.com/comments/2007/11/sp500-ex-risk.html
Sources:
Summary of Statement No. 157
Fair Value Measurements
http://www.fasb.org/st/summary/stsum157.shtml
Auditors Resist Effort To Change Mark-to-Market
JUDITH BURNS
WSJ, SEPTEMBER 30, 2008, 4:29 P.M. ET
http://online.wsj.com/article/SB122280147924091325.html
What part of mark-to-market don't you understand?
Justin Fox
Time's Curious Capitalist, September 30, 2008 8:17
http://time-blog.com/curious_capitalist/2008/09/what_part_of_marktomarket_dont.html
SEC, FASB Resist Calls to Suspend Fair-Value Rules
Jesse Westbrook
Bloomberg, Sept. 30 2008
http://www.bloomberg.com/apps/news?pid=20601087&sid=agj5r6nhOtpM&
How to Start the Healing Now
Fix accounting rules and private money will come.
BRIAN WESBURY
WSJ, OCTOBER 1, 2008
http://online.wsj.com/article/SB122282734447293049.html
Wednesday, October 01, 2008 | 08:00 AM | Permalink
| Comments (95)
| TrackBack (0)
add to de.li.cious | 
digg this! | 
add to technorati | 
email this post
TrackBack
TrackBack URL for this entry:
http://www.typepad.com/services/trackback/6a00d8341c52a953ef01053510f1d4970b
Listed below are links to weblogs that reference Understanding the Significance of Mark-to-Market Accounting:
Comments
It appears that if we are to avoid this mess, we'll all have to wage a public PR campaign against Wall Street, the banks and anybody else in support of suspending mark-to-market accounting.
I would urge everyone to spread this message via blog posts, blog comments, e-mail to friends, e-mail to your government representatives.
Regards,
George
Posted by: Agoracom - George | Oct 1, 2008 9:03:02 AM
consider:
"banks must pay county property taxes on all held property on a quarterly basis"
versus:
current system of the next buyer pays all property taxes
will:
put some jump in their step to price assets to sell
Posted by: Greg0658 | Oct 1, 2008 9:05:34 AM
Gotta agree with ya Barry....all this weeping and gnashing of teeth over mar-to-market is nothing more than pure bullshit.Most of the Congress decrying the system have absolutely no idea what it is they are talking about. Rep Tom Price of Texas said on Bloomberg yesterday he didn't understand mark-to-market but it was a free market principle if it was abandoned,
Corporate titans know better but hey why speak out for it when if it's abandoned/suspended they win.
Oh when is Gasbag going to join the list of unemployed.
Posted by: GRUMPYOLDVET | Oct 1, 2008 9:06:36 AM
No one argues that the companies need to mark-to-market liquid assets. The real issue comes as to what to do with illiquid assets. The rule should never ever be applied to illiquid assets because this rule over inflates (overprices) the assets of the way up and over deflates (under prices) the assets on the way down. (somewhat similar to illiquid AH trading in stocks)
Posted by: Marek | Oct 1, 2008 9:19:38 AM
Indeed, I know of no faster way to end up on the DO NOT OWN list than to hide from your shareholders what is on your books.
Dunno if it's faster, but being on the 'do not short' list is a pretty quick way to get on the 'do not own' list... When you need the gummint to change the rules just for you, that's a pretty big red flag..
Posted by: Dr. Kenneth Noisewater | Oct 1, 2008 9:21:02 AM
I couldn't believe this one but then I learned it was being pressed by those folks in the house who think tax cuts were the solution. The guys Tom Friedman says probably couldn't balance their own checkbooks and I suspect he's not far wrong. If this gets by I'm going to value my house at about 2 million above local comps and get a home equity loan on the new valuation. Seriously this has to be beaten back. Hopefully someone like Uncle Warren will deliver a reality check.
Posted by: John(2) | Oct 1, 2008 9:27:15 AM
And just an addendum: Wesbury's promoting it. ARRRRRGGGGGGHHHHHHHH
Posted by: John(2) | Oct 1, 2008 9:28:32 AM
I just want to thank you for this excellent explanation. Your blog is extremely helpful even for those of us who are just watchers of the play.
Posted by: Aunt Deb | Oct 1, 2008 9:30:28 AM
I'm really not a financial guy so I'd appreciate it if somebody could help me out with this.
The way I understand it is, if I'm in the business of trading say, Oranges, and I buy a bunch of Oranges that have been contaminated with something that makes them so radioactive nobody wants to buy them this FASB157 rule dictates that I must markdown the value of my Orange inventory to zero?
And if the FASB157 rule is eliminated I can value my radioactive Orange inventory to any value I like and not reflect anywhere in my financial statements that I have so arbitrarily valued my inventory?
As I understand it, I agree with everything the author of this article says, especially the point about bullshit investments and the creators of such that implemented an unregulated thinly traded so called market to trade the ponzishares they created.
Lastly, intuitively, this whole mark-to-market debate Washington is giving us seem to me like a rope-a-dope.
Posted by: Clint Golden | Oct 1, 2008 9:30:50 AM
Clint,
other than the Fact that FAS 157 has, mostly, to do w/ Financial Instruments, you're on the right track.
see: Summary of Statement No. 157
Fair Value Measurements
Summary
This Statement defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. This Statement applies under other accounting pronouncements that require or permit fair value measurements, the Board having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, this Statement does not require any new fair value measurements. However, for some entities, the application of this Statement will change current practice.
Reason for Issuing This Statement
Prior to this Statement, there were different definitions of fair value and limited guidance for applying those definitions in GAAP. Moreover, that guidance was dispersed among the many accounting pronouncements that require fair value measurements. Differences in that guidance created inconsistencies that added to the complexity in applying GAAP. In developing this Statement, the Board considered the need for increased consistency and comparability in fair value measurements and for expanded disclosures about fair value measurements.
Differences between This Statement and Current Practice
The changes to current practice resulting from the application of this Statement relate to the definition of fair value, the methods used to measure fair value, and the expanded disclosures about fair value measurements.
The definition of fair value retains the exchange price notion in earlier definitions of fair value. This Statement clarifies that the exchange price is the price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. Therefore, the definition focuses on the price that would be received to sell the asset or paid to transfer the liability (an exit price), not the price that would be paid to acquire the asset or received to assume the liability (an entry price)...
http://www.fasb.org/st/summary/stsum157.shtml
past that, nice work BR, a succinct unpacking of this issue, at hand.
Further, just a rhetorical Q: "Given the share price of GOOG, Am I Really the only one that has a web-browser that'll field results for www.google.com?"
Posted by: Mark E Hoffer | Oct 1, 2008 9:43:18 AM
A thought from an ignorant fan of yours.
I think I understand your point. However, it seems to me that marking to a market where there are no trades is as illusionary as marking to some theoretical model. How about having an adjustable average between marking to model (or yield to maturity) and marking to market? The average should be 100% mark to market when the market is liquid (e.g. stocks) and closer to 100% model when there are no trades going on. Or maybe we should require firms to report both methods.
Posted by: Michel Caldwell | Oct 1, 2008 9:43:49 AM
Posted by: Michel Caldwell | Oct 1, 2008 9:43:49 AM
Michel,
simply, illiquid G**bage that doesn't trade (noone wants), isn't an 'Asset', it's a Liability.
Posted by: Mark E Hoffer | Oct 1, 2008 9:46:31 AM
Does eliminating the "mark to market" rule mean that any firm can "adjust" their assets to some murkily derived value just as the financials will be allowed to do? I remember back in the early 1980s when firms and banks in Texas were going belly up right and left as the petroleum price fell from $40 per barrel to $10 per barrel and these enterprises had to adjust the loans which had been made with these oil reserves pledged against the loan. Should those firms have been allowed to keep the asset values at $40 per barrel - maybe even adjust them higher - since everybody knew that in the long run the price of petroleum would go even higher? How much special coddling does the financial services industry need in order to remain viable? Maybe we should nationalize the whole mess.
Posted by: PrahaPartizan | Oct 1, 2008 9:49:06 AM
Yes Ai! Way to go Barry. The truth is out folks.
In (semi-)related news:
Isn't it funny how all the former free marketers have started yammering about 'actual value' as opposed to market price of an asset? What were these guys too busy doing beer bongs to attend class the day their econ101 teacher explained that in free markets supply and demand set the price and 'inherent value' is a completely non-economic notion -- one for those wooly librul do gooders that believe in things like inherent worth. The gold bugs are also pretty funny about this -- free markets uber ales, but Gold has 'inherent value'. It's just not inherent to its demand (use) or supply (there's lots more where that came from).
Posted by: VoiceFromTheWilderness | Oct 1, 2008 9:49:13 AM
Good post, Barry. I also think that to suspend mark to market at the time of a crisis in confidence is pouring gas on the fire. Kind of like proposing a capital gains tax cut, when you are approving a $750 billion expenditure.
Posted by: larster | Oct 1, 2008 9:49:36 AM
The flip side of mark-to-market rules is that liabilities are marked to market as well.
Since a failing firm's liabilities decline in value as it fails, you can have the conundrum that a firm starts looking profitable just before it goes under.
Maybe those "profits" before implosion can be the source of capital needed to save the firm.
Posted by: Donkei | Oct 1, 2008 9:50:39 AM
A Republican Congressman (voted against bailout Monday) on the Rachel Maddow show was rallying for abandoning the mark-to-market requirement. I turned to my wife and said, "sure, let them just make up values, that's bound to work"
Posted by: lutton | Oct 1, 2008 9:52:10 AM
Michel, these assets HAVE traded but at a much lower price than the banks want to recognize/admit. They don't want to mark down their entire "warehouse" of inventory to the observed prices for the few trades that have been forced (via banks either desparate or in bankruptcy).
And bank assets "in foreclosure" *are* the market, just like a house still has value in foreclosure. All the sellers (homeowners and banks alike) holding out for "2005 bubble prices" are simply avoiding reality.
Posted by: wunsacon | Oct 1, 2008 9:58:08 AM
FNMA/FHLMC, lenders, banks were sold on FICO credit scoring as a way to assess risk. The assumption was a certain credit score determined the likelihood of default. Higher FICO score meant lower risk.
You could get a no verification mortgage in seconds with a sufficiently high FICO score. Banks and consumers loved it.
Packaging of loans was based, in part, on FICO scores.
Well, that whole model has been blown to shreds.
The FICO model must never have been stress-tested.
If you have a pool of mortgages you bought based on FICO, and now FICO is a meaningless number, then you are left with essentially nothing on which to base a value.
Posted by: cloudy | Oct 1, 2008 10:01:11 AM
I can understand the s--tpile owners pushing this, but who in the US gvt is? Who is responsible to oversee (cough, hack) this? SEC? Some other regulatory (cough, hack) agency?
Please excuse me for now getting partisan, but for any nation to elect GW Bush TWICE given his long previous history of ineptitude and crudeness, maybe we should file this collapse under 'Karma'.
Posted by: p.a. | Oct 1, 2008 10:06:19 AM
This is far afield for me. It sticks in my head for whatever reason that mark-to-market was originally created when the market was rising so that companies could raise their balance sheet based on the inflated values. Many of these financial instuments as far as my understanding goes used to sit on the balance sheet at a significant discount to market value because companies didn't want to have to take large losses come bad times. I think Warren Buffet said something about having to mark his stocks higher than he thought they were worth due to the accounting rule change. Does any accountant and finance guy know more on this? I could just be wrong.
Posted by: M.Z. Forrest | Oct 1, 2008 10:08:35 AM
Great post. Thanks for the info on this topic. I'm disappointed supposed 'free market capitalists' would want this rule suspended.
Posted by: Jay | Oct 1, 2008 10:09:31 AM
Mark to market suspends reality? Are you kidding? Does anyone truly believe Wall Street and politicians haven't already suspended reality? They did so loooooong ago.
They can do anything they want to do with their accounting rules. This has nothing to do with real estate or its associated debt. They can shake it, bake it, fry it or anything else they want to do with it. In fact, they can shove it where the sun doesn't shine. None of it will stop the environment we see unfolding.
Correlation is not causation and they will find this out soon enough.
Posted by: bdg123 | Oct 1, 2008 10:09:36 AM
there is no such thing as an "illiquid" asset. there's always liquidity, and a price, where something will trade. the rule that shd come out of this is that financial companies should never own things that some describe as illiquid. does not fit their business model. a pension fund can own timber, not a bank. financials and those who love them should accept reality.
Posted by: scorpio | Oct 1, 2008 10:10:36 AM
as i understand it, fasb 157 divides "investments" into 3 categories: lv1 mtm on actively traded stuff. lv2 "fair value" as defined by what a willing buyer would pay to a willing seller. lv3 mtmyth, as warren said. changing or eliminating the marks would look better, i guess, on valuation of abs of one sort or another, but the coming problems are direct loans: mortgages, cc receivables, junk loans, c&d loans, etc. none of these are subject to fasb 157, as i understand it, and get reserved against as the loans go delinquent (or worse) something that will continue at an increasing rate going forward.
Posted by: clipc | Oct 1, 2008 10:11:07 AM
