[Todd Zywicki, September 22, 2008 at 4:55pm] Trackbacks
Mark-To-Market:

In an earlier post I noted in passing the role of changes in accounting rules and the role that played in bringing the financial crisis to a head at this time. John Berlau has helpful deeper discussion in a WSJ column here and blog post here. It is plausible that mark-to-market contributed to bring this to a head. Nonetheless, I'm not sure that I agree with Berlau's conclusion of relax mark-to-market (of course, I'm not sure that we shouldn't relax mark-to-market either)--it really depends on whether mark-to-market is creating liquidity problems or preventing deeper fraud. Berlau seems to believe the former and Paulson the latter.

Update:

Hans Bader has more.

NickM (mail) (www):
How about both?

Nick
9.22.2008 6:00pm
asdffsda:
Can someone explain how an accounting rule could substantively effect investment in a corporation? The underlying income stream, or value, of the mortgages has not changed. So how could it matter whether these are assessed under mark-to-market or some other rule?

I just don't understand the point of Berlau's observation here. I mean, investors know of the accounting rules, don't they account for these rules in their decisions about securities and companies?
9.22.2008 6:21pm
Mike S.:
To asdffsda: it depends how much research you can do; if you price the notes backing the security, you may not care, but if you look at the posted asset value, you will be influenced by the accounting rule.

In general, mark-to-market is a good rule that prevents both self-delusion and fraud. however, in the middle of a liquidity crises, it is true that it probably tends to exaggerate how bad things are, when prices are temporarily depressed from rational values by a panic. After all, if 20% of mortgages are in default and the value of mortgage backed securities is down 90% or more, something is out of whack.
9.22.2008 6:28pm
CPA 3L:
So now itst all the accountants' fault for forcing banks to value their crappy mortgage investments at FMV? The banks are insolvent because they lost billions on these mortgages; the accounting rules merely reflect that.
9.22.2008 6:37pm
ArtEclectic (mail):
Why is that all sorts of blame gets tossed around and everyone conveniently forgets the historic amounts of fraud that the mortgage industry contributed to the problem.

http://www.cjr.org/essay/boiler_room.php?page=all

Why aren't these people in jail?
9.22.2008 6:59pm
Alan Gunn (mail):
Mark-to-market, like short selling, gets blamed because it is a bearer of bad news.

(This is just another way of putting CPA 3L's point.)
9.22.2008 8:03pm
byomtov (mail):
I don't understand the objections to mark-to-market. Does it cause a liquidity problem sometimes? Maybe, but from the point of view of the lender it's a legitimate problem. To argue otherwise is to say that it should be OK to misstate the value of assets to lenders. In some circumstances you can go to jail for that.

Besides, didn't that sort of thing contribute to the current problems when the assets in question were houses and mortgages?
9.22.2008 8:06pm
SFBurke (mail):
There has to be some mechanism to ensure that securities on the balance sheets of banks, insurance companies etc. are accurately valued. Otherwise, these institutions will operate like they are fully capitalized when, in fact, they are on the brink disaster. The result is just defering a mess and allowing it to get bigger. In an "illiquid market", it may be difficult to effectively to "mark-to-market" because one or two trades are not sufficient to provide "market" information. On the other hand, the fact that a someone is forced to sell in a "panic" at $0.20 on the dollar (like Merril Lynch did with a big chunk of its mortgate securities) strong suggests that a substantial mark down is required even if the obligations don't meet some technical definition of being impaired.
9.22.2008 8:11pm
DeezRightWingNutz:
The issue is when there isn't a market. If no one is buying and selling, there's no market. But that doesn't mean that the value is zero. Furthermore, mark-to-market works best for fungible assets with lots of sales volume. Share number 1234932 of GM's common stock (which just sold 3 miliseconds ago) is a pretty good comp for GM common stock share number 5842043. As assets become more unique, the process becomes more difficult.
9.22.2008 10:22pm
byomtov (mail):


Hans Bader? This is actually interesting.

In 2003 the WSJ editorial page wrote that Barney Frank criticized Mr. Mankiw because he is worried about the tiny little matter of safety and soundness rather than "concern about housing."

Note the quotation marks. The business about safety and soundness was the WSJ's interpretation of Frank's remarks, not a quote.

Now comes John ("the dog ate my data") Lott, who writes,

The Wall Street Journal quoted Congressman Barney Frank in 2003 as criticizing Greg Mankiw, chairman of President Bush's Council of Economic Advisers, "because he is worried about the tiny little matter of safety and soundness rather than ‘concern about housing.'"

If you pay very careful attention to the double and single quotes you just might realize that Lott is quoting not Frank, but the WSJ's interpretation on "safety and soundness." Not to accuse Lott of being deceptive or anything.

Now Hans Bader's version, linked from Lott, in which he attributes the WSJ line to Frank:

[Frank] ridiculed whistleblowers like Greg Mankiw, chairman of the Council of Economic Advisers, whom he mocked for being “worried about the tiny little matter of safety and soundness rather than” the liberal goal of promoting affordable housing..

So Bader, at best, was quite careless. At worst he deliberately misrepresents the incident. Perhaps he's not the most reliable person to cite.
9.22.2008 10:42pm
Elliot123 (mail):
Note that MtoM works both ways. When the market is down, the value of the portfolio is marked down. When it is up, the value is marked up.
9.23.2008 12:38am
fullerene:

Note that MtoM works both ways. When the market is down, the value of the portfolio is marked down. When it is up, the value is marked up.


We quickly forget, don't we? Enron aggressively used mark-to-market to inflate its profits. Its fall came when those bogus calculations were revised downward.
9.23.2008 12:58am
Norseman:
Well to defend the banks against mark to market, if I lend $100,000 on a house worth $400,000, and the borrower is current on the mortgage, why should I care that the market price for that asset is $88,000 today? I don't plan on selling it today, the borrower is current, and if if the loan did default, I'd have enough collateral to be made whole. Of course three years ago, BBB subprime mortgages were going out the door with a 7.5% yield ...
9.23.2008 7:39am
byomtov (mail):
why should I care that the market price for that asset is $88,000 today? I don't plan on selling it today, the borrower is current, and if if the loan did default, I'd have enough collateral to be made whole.

You very well may not care. And if you are a private lender, self-financed, it doesn't really matter.

But suppose you are in the lending business, like a bank. You essentially borrow money and relend it at a higher rate. Then those who lend you money, or insure your depositers, or buy equity in your business, are entitled to know the actual market value of your holdings. After all, that's what they are buying an interest in, or lending against, or whatever.

Remember, the $88K is not an arbitrary number picked out of the sky. It reflects a lot of factors, of which the current value of thecollateral and so on are only a part.
9.23.2008 12:45pm
silverpie:
As a business appraiser in a CPA firm, I see similar issues all the time. The problem is that we have conflicting definitions of the word value. The new rules essentially define value as "what you can cash out for today." In some circumstances, this may be the important number to know, but in others, it's more important to know the intrinsic value--the present value of what you can expect to receive from it, allowing a proper rate of return for the risk involved.

The problem occurs when readers of a balance sheet, who are used to seeing numbers closer to intrinsic value, suddenly see lower market-snapshot numbers and think it's an intrinsic number. This may have a substantive effect in the case of banks, where the reduction can throw you out of regulatory compliance, or where a loan covenant is endangered. (Kind of like playing a basketball game and having the 3-point shot retroactively repealed.)
9.23.2008 9:48pm
Michael F. Martin (mail) (www):
This is actually very simple economics. Mark to Market is a disaster from the point of view of an investor interested in assessing the book value of a company.

If assets are carried at cost, the INVESTOR can consult the market to see what the assets would be worth in liquidation, and thus the INVESTOR can determine whether she has a margin of safety in purchasing a company based on its book value.

When the company is permitted to mark its assets up (or down), investors lose a key reference point -- cost -- which is necessary to determining the underlying value of the company.

It's really not more complicated than that. Enron, Worldcom, Bear Sterns, now Lehman. How many more examples do we need to prove that mark to market is an inherently unstable mechanism for accounting for asset value?
9.27.2008 1:57pm
Michael F. Martin (mail) (www):
I'll just add that in general the problem with the "free market" right now is that professional accountants have too much control over the accounting standards. Their reaction to each crisis has been to further limit the amount of information available to investors and the public whereas more information and less editing and summarizing are what is necessary for a free-market to stabilize.
9.27.2008 1:59pm