Mark-to-Market, RIP?

Churchill’s famous dictum, “Democracy is the worst form of government, except for all those other forms that have been tried from time to time,” could also be applied to mark-to-market accounting. However, like democracy, mark-to-market may be on its last legs. The stock market rally of late last week was fueled by the rumor that Timothy Geithner’s “save the bank” program, now due to be presented on Tuesday, will include a relaxation of accounting rules.

The bad feature of mark-to-market accounting, as it opponents are letting anyone who will listen know, is that it is pro-cyclical. In good times, asset values rise, which creates accounting gains for banks and financial firms that in turn boost their equity capital. Now in this competitive world, no self-respecting firm (at least of the American persuasion) wants to have idle capital, so they go out, willy nilly, to borrow and invest more.

Funny how no one had a problem with that feature in the good times. But in the bad times, the process goes into reverse: shrinking asset values are a direct hit to equity capital, which necessitates further balance shrinkage to get equity ratios back in line.

So if this is such a terrible system, why was it implemented in the first place? Because other approaches gave bankers considerable latitude in how they valued assets, which they can and frequently did abuse. And the funny bit is that the generous valuations would typically come a cropper in bad times.

Now various pundits have come up with ways to combat procyclicality (for instance, having countercyclical capital requirements; some of these proposals have been worked out in some detail).

However, the financial sector has been crying for relief now, arguing that mark to market is painting an unflattering picture. I’m not sure I buy that at all. Given that the Treasury is still considering a “bad bank” plan, that suggests that there are plenty of assets on bank balance sheets at fictive values (otherwise, if they were at true market prices now, they’d be able to sell them and move on, and the damage would already be reflected in their equity). William Black, a former FDIC examiner, says the the accounting fraud in banks is at Enron levels.

Moreover, the idea that this move will make matters better is delusional. The reason banks are unable to sell equity now is that investors do not trust their financial statements. They can’t tell a good bank from the “impaired but might make it” and “radioactive” varieties, so they shun them all. Further obfuscating the accounts puts them all behind a veil. It makes it even harder to sort out quality, and will lessen rather than increase trust.

Lloyd Blankfein, in a Financial Times comment, concurs:

Last, and perhaps most important, financial institutions did not account for asset values accurately enough. I have heard some argue that fair value accounting – which assigns current values to financial assets and liabilities – is one of the main factors exacerbating the credit crisis. I see it differently. If more institutions had properly valued their positions and commitments at the outset, they would have been in a much better position to reduce their exposures.

For Goldman Sachs, the daily marking of positions to current market prices was a key contributor to our decision to reduce risk relatively early in markets and in instruments that were deteriorating. This process can be difficult, and sometimes painful, but I believe it is a discipline that should define financial institutions.

Tyler Durden does a good job of recapping the current rules and discusses the expected fix:

The table below, courtesy of UBS, summarizes some of the key concepts incorporated in FAS 115, but the gist of the rule is that losses or impairments are handled differently depending on the categorization of the asset: trading, available-for-sale or held-to-maturity. This rule will likely gain more visibility in the coming months, as it provides a tidy loophole for commercial banks (which post September 15 includes virtually all major financial institutions), which make heavy use of the available-for-sale security categorization. Securities classified as available-for-sale or held-to-maturity can be categorized at temporarily impaired when Fair Values fall below amortized cost: this is relevant since impairments defined as temporary are reported as a component of Accumulated Other Comprehensive Income (AOCI) and have no effect on income or regulatory capital. The issue arises when an impairment is defined as other than temporary, or written down from a previous temporary status, as the securities then must be written down to fair value, which impairs earnings and regulatory capital. The fair value also becomes the new cost basis and may not be written up for subsequent recoveries in Fair Value, but rather hit AOCI, thus not having a favorable impact on regulatory capital in an improving economic environment! As a side note, unlike commercial banks, broker dealers can not use the temporary impairment loophole as all their assets are categorized as trading, and thus all gains and losses are transparent and immediately have an impact on the bottom line and capital.

An interesting point that UBS brings up is whether the upcoming wave of financial company earnings releases will show commercial banks with significant available-for-sale holdings recording temporary impairments. And if that is in fact the case, what is the nature of these assets and what is the likelihood these will eventually have to be written down over time if values do not recover. FAS 115 requires that disclosure of temporarily impaired securities be broken down into those impaired for less than 1 year and more than 1 year, together with a security description, and calculation of unrealized losses (FV – cost) for each type of security. It is expected that after 12 months of temporary impairments, commercial banks may be pressured to take write-down on many categories of temporary impairments.

It is not surprising that as we anniversary the events from Bear Stearns, which set off so many asset reclassifications in motion, there is a substantial push to do away with Mark-to-Market altogether. It is feasible that banks anticipate having to disclose significant temporary impairments on RMBS, CMBS and other wholesale impaired portfolios in this, and likely even more so, the next quarter, and have been lobbying the administration behind the scenes for much loosened accounting standards, while maintaining a public facade which extols the virtues of Mark-To-Market. As the earlier clip with Kanjorski indicates, the administration is terrified of a repeat bank run, so Wall Street has a carte blanche to “educate” Congress and Senate in any way that benefits its interests, it is a highly likely outcome that Mark-To-Market will be done away with entirely. Even though this event will incite another brief market rally as the ugly truth is hidden from investors, this time however with the government’s blessing (and the assumption that taxpayers will foot the bill for any Fair Value-to-Cost disparities), we believe that the ultimate outcome will be a destruction of value of unseen proportions. All MTM abolition will do is stop dead in its tracks the weak ongoing attempt at market transparency, and veil the entire market with a shroud of inability to calculate the true worth of any single asset. And of course, the ultimate beneficiary in the near-term will be Wall Street, while taxpayers will, as always, foot a staggering long-term cost. We hope we are wrong.

Print Friendly, PDF & Email


  1. doc holiday

    Re: William Black, a former FDIC examiner, says the the accounting fraud in banks is at Enron levels.

    > Say it Sister, say it! I hear yah, but do they hear yah in the choir loft?

  2. Anonymous

    Speaking of planning accordingly, does anyone have any info on where the best tax havens are these days now that Switzerland is ratting everyone out?

  3. mxq

    “Lloyd Blankfein teaching us about accounting? Can’t believe this…”

    Its not that hard to believe. GS ditched the institute of international finance back in july 08 after the IIF decided to abandoned mark-to-market. GS called the suspension of mk-to-mkt “Alice in Wonderland Accounting.”

    LIII is where assets and liabilities go when there are no inputs. But if you roll back fas 157, the entire balance sheet, for all intents and purposes, becomes LIII and any hope for transparency goes bye-bye. So gs and ms (they threatened to ditch iif too) view fas 157 as a source of competitive advantage vs. other banks…b/c they know their mk-to-mkt stuff reflects the realities (and vagaries) of the market.

    (long gs)

  4. bg

    If we have Enron level accounting fraud, then it should not be a surprize that there is a loud cry to keep the corpses buried until the next tide comes in.

    I really especially dislike ‘intent’ based accounting, which should not be hard to shred the logic.

    If I buy a junk bond with the intent to hold it to maturity (as a friend of mine did), and then dumps it when he reallizes it was less of an annuity, and more like selling earthquake insurance, and then dumps it. Because he ‘intended’ to hold this ‘annuity’, should he be allowed to use it as collateral at face value? Of course not!

    Pro-cyclical is a problem, per Minsky, but the solution is not to fertilize more during winter. It is better to put more into barn in Autumn.

  5. Independent Accountant

    I have had about six posts on this issue. Why anyone believes the Feds want better as opposed to worse accounting is beyond me.

  6. Anonymous

    Whew! Good thing we don’t have any more brokerage banks, they all morphed into financial banks to avail themselves of bank accounting standards. Genius.

    Stall tactics to delay filing insolvency papers. If banks can stretch this out to…say….the year 2020, they might stand a chance of recovery as long as they start bulldozing all the excess housing tomorrow.

  7. cap vandal

    Tyler Durden and Lloyd Blankfein can’t both be correct. Per Tyler, GS is shifting assets to level 3, avoiding the very mark to market that he now seems to be pushing.

    This is a very complicated, but most of what Tyler was discussing amounts to very little. That is, GAAP capital is identical whether fair value losses are run through net income or AOCI. It’s disclosed, and the only impact is on regulatory capital.

    The impact of this is to reduce regulatory capital requirements without stating that you are doing it.

    This is no different then C’s loan loss provisions for 3rd world losses in the 80’s, that still counted (due to a waiver from the Fed/Volker) as regulatory capital.

    The entire rationale of spitting earnings into “normal” or net earnings and other comprehensive income is to segregate the “noise” from unrealized capital gains/losses. The numbers are still there, staring anyone in the face that cares to look.

    Mark to market is required for all derivative books and is totally appropriate for investment banks. Traditional banks should stick to whole loans. There is a mechanism for the inherent mismatch in assets and liabilities — regulation and deposit insurance.

  8. cap vandal

    clarification — on a GAAP balance sheet, stuff gets marked to “fair value” per Tyler but only the permanent impairment gets booked to net income.

    The balance sheet change wouldn’t equal the income statement net income (forget dividends for now). The “answer” is another item called other comprehensive income(loss).

    Sometimes this is very useful and totally appropriate.

    For everyone that is totally enamored with m2m, C and BAC’s preferred stock’s MARKET VALUE is now about 50% of par. This the the NYSE listed stuff — not some Markit estimate/index/matrix. Should they write it down and book the profit? After all — markets are markets, no?

  9. fresno dan

    I’m like the banks – I’m not insolvent because I bought all that at 400$ a share…no, I’m just waiting for a market for at 400$ a share. Its been going up lately – I expect in 150 to 300 years I’ll be in the black.

  10. Anonymous

    Durden said: “veil the entire market with a shroud of inability to calculate the true worth of any single asset”

    There has always been, and always will be, an “inability to calculate the true worth” of an asset. This is why we have markets in the first place. The expression “true worth” has no meaning – as if there’s some magic number that you only have to find that truly reflects the asset’s value.

  11. JKH

    The problem with MTM accounting is that most people view it as a necessary condition for transparency (in the usual financial sense of that word).

    It isn’t. It is sufficient, but not necessary.

    The necessary condition for transparency is MTM disclosure.

    The necessary and sufficient condition for transparency is MTM disclosure without MTM accounting.

    Disclosure is different than accounting. Accounting affects capital. Disclosure doesn’t necessarily affect capital. Disclosure without MTM allows the matching of time horizons between the life of assets and their effect on capital. And it allows shareholders to make an independent judgement on the effect of MTM disclosure on the market value of equity. In this sense, MTM accounting forces a double-up valuation of MTM in both the book value and market value of equity. This redundancy is absolutely dysfunctional.

    As to exactly what the best complementary accounting to MTM disclosure might be, I don’t know precisely.

    But the more critical point is to understand at the outset that MTM accounting is not necessary for transparency, and that it is accordingly suboptimal for accounting and capital measurement.

    I think this logical imbroglio may be why there is such a division of opinion between two groups of thinking on the issue, both of which include reasonably intelligent and experienced people.

  12. Anonymous

    I’m all OK for a change in accounting but at one condition: that all earnings for the past 10 years be recomputed using the new rules and bonus adjusted (clawbacked) accordingly.

  13. Anonymous

    This column is total nonsense. Mark-to-market is what is CAUSING the lack of clarity in asset values. We can know this because mark-to-market was forced on the industry, and the result is that no one has any clue what any asset is now worth. Just because you think you are morally superior to mark-to-model doesn’t mean that it doesn’t work and that it is invalid.

    “The reason banks are unable to sell equity now is that investors do not trust their financial statements.”

    Investors don’t trust the GOVERNMENT and what it will do to the banking sector. Where investors distrust the financial statements of banks, it is because banks have been forced to mark their assets to market, even though the vast majority of them have cash flow. Would YOU buy into assets that were being force-devalued by the government, even though they were making money?

    Who died and made mark-to-market God?

Comments are closed.