Mark-to-Market Accounting: What You Should Know

You know you're in a financial crisis when a technical accounting rule becomes front-page news. The financial rescue bill the Senate approved yesterday includes a heavy-handed signal to the SEC to consider suspending "mark-to-market" (MTM) accounting.

Applying MTM accounting has forced banks to recognize billions of dollars in losses on mortgage-related securities; critics contend the practice has worsened the credit crisis. Are they right?

What is mark-to-market accounting?
Loans and securities make up the bulk of a bank's assets. Thus, the method you use to establish values for these securities when preparing your financial statements affects shareholders' equity. (Shareholders' equity = assets – liabilities, remember?) That, in turn, has an effect on a bank's profit and loss statement.

Mark-to-market accounting sets the value of (or "marks") the assets on your balance sheet to reflect their market sale prices. In theory, that all sounds nice and clean. In practice, things get a little messier.

All the way down to Level 3 hell
Not all securities are as liquid as Microsoft shares, for which anyone can look up the price on the Internet at any given moment. Some mortgage securities may not even trade once a day; what prices will you use for those?

To address this, there is a hierarchy of assets, with a set of guidelines for each:

  • Level 1 assets have market prices.
  • Level 2 assets don't have market prices; they're marked at fair value based on a model. The model is fed with inputs for which there are market prices (prices of similar securities, interest rates, etc.).
  • Level 3 assets don't have available market prices for the model inputs, forcing the people preparing the financial statements to make assumptions about those inputs' values.

As you can imagine, in a market like this one, the resulting value for Level 3 assets may be highly questionable. "Mark-to-imagination" might be a more suitable term in this case.

(I wonder how Warren Buffett factored that into his decision to invest in General Electric (NYSE: GE  ) ? After all, GE Capital has nearly $16 billion in Level 3 assets on its books.)

Does the market always know best?
The problem with MTM accounting is that it relies on the notion that the market is an asset's best arbiter of value. Most of the time, that's a fair assumption, but it breaks down in a market crisis. When investors are gripped by fear, panic-selling can produce prices way out of whack with underlying asset values. Worse, a market may stop trading altogether.

Even the Financial Accounting Standards Board and the SEC issued a clarification of the accounting rule known as FAS 157 on Tuesday, saying that the price of "disorderly" trades (distressed selling or forced liquidations) isn't "determinative" when measuring fair value. And since it's difficult to imagine a market more disorderly than the one we're in right now, when it comes time to do the books, accountants are basically taking a guess and hoping for the best.

The resulting uncertainty creates a very real problem. The Bank for International Settlements (basically, "the central bankers' central bank") has suggested that applying mark-to-market accounting to triple-A-rated subprime mortgage securities, using the ABX index -- which tracks the current market value of such securities -- as an input, could overstate expected total losses by as much as 60%.

Your credit is no good. Here's your reward!
In addition to muddying up asset values, MTM accounting creates a mirror problem on the liability side of the balance sheet. Paradoxically, as the price of a bank's bonds falls (indicating that the market believes the bank's risk has increased), banks have been able to report these changes as gains on the income statement. The riskier the bank becomes, the richer it gets -- on paper, at least.

Here's how it works: The bonds a bank issues are part of its liabilities. When their value decreases, shareholders' equity technically increases. (Remember, shareholders' equity = assets – liabilities.)

We're not talking small numbers here, either. In 2007, Citigroup (NYSE: C  ) , Merrill Lynch (NYSE: MER  ) , Morgan Stanley (NYSE: MS  ) , Lehman Brothers (OTC BB: LEHMQ.PK), Goldman Sachs (NYSE: GS  ) , and Bear Stearns (now part of JPMorgan Chase (NYSE: JPM  ) ) booked $12 billion in aggregate gains related to this rule.

A prophetic vision from 2005
But wait -- it gets even worse. A farsighted academic paper from 2005 suggests that mark-to-market accounting amplifies the boom-bust cycle in asset prices. Especially in a financial crisis, it can magnify the level of distress. If the authors are correct, mark-to-market accounting may not be superior even with a normally functioning market and plenty of liquidity.

According to the same paper, mark-to-market accounting also fuels the "reach for yield," as we witnessed in abundance during the run-up to the crisis. With interest rates near historical lows and the credit faucet running full blast, banks and investors took on massive amounts of (mispriced) risk just to earn a few extra basis points of interest. The only predictable outcome of this large-scale phenomenon: the massive losses now devastating the banking system.

Based on my preliminary research, I think that the Financial Accounting Standards Board and the SEC should reconsider the legitimacy of MTM accounting. That said, suspending or abolishing the practice isn't a cure-all for the banking crisis. Even under current rules, bankers already have enormous discretion in how they choose to value their most troublesome, least liquid assets.

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Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the companies mentioned in this article. JPMorgan Chase is a Motley Fool Income Investor recommendation. The Motley Fool has a disclosure policy.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On October 02, 2008, at 7:10 PM, otterknow wrote:

    It isn't rare enough that this type of accounting comes up. I own a small firm that does these types of valuations for PFIC(Passive Foreign Investment Corps...UK Trusts) and CFC's(Controlled Foreign Corporations..US people having business investments offshore) and have used this method on several occasions. My biggest problem is it's lack of accuracy. Typically, this is done at year end unless the asset is sold at some point mid year.

    If the valuations are done in foreign currencies you are twice as distant from real value. Then let's hope someone qualified and detailed is doing the work or you'll have a whole new puzzle to figure out.

    I'm seriously 2 more fiscal policy mistakes from moving to Europe...I didn't know that doing whippets while making reporting decisions was the new craze..yet here we are. Yikes!

  • Report this Comment On December 16, 2008, at 5:01 AM, sgtym wrote:

    Actually, there was an article published in 2004 which said that using market values, and taking holding gains and losses into income (which is what fair value accounting requires), will be harmful.

  • Report this Comment On January 27, 2009, at 1:23 PM, babypoop wrote:

    Yeah, apparently capitalism only works when people want to buy stuff. If they don't want to buy what your selling, better to have 'central planning' determine the price.

  • Report this Comment On January 28, 2009, at 2:35 PM, bizwiznatalie wrote:

    Mark-to Market rears it's ugly head again. Didn't we learn our lesson with Enron?

  • Report this Comment On February 07, 2009, at 9:28 AM, j1d2j3 wrote:

    don't understand the problem valuing items ex. bonds should be carried as a liability at redemption value (liability), not current value. Redemption value of the bonds is the liability obligation of the issuer, if they can be purchased at a discount that would be accounting entry (purchase price is an expense) at the time of the bond repurchase and bond liability removed from books (where they had been carried at the redemption value ). Other assets and libalities should be valued based on the value of comparables unless they are covered by an indenture or contract which covers their value.

    ,

  • Report this Comment On February 12, 2009, at 10:10 PM, BarbJL wrote:

    When Wall Street started crumbling down....I heard

    several people mention that if the SEC would eleminate the Mark-to Market it would turn things around.............Can someone, in VERY simple words explain to me what Mark to Market is and how it works? In the last week I have read two

    different articles that have mentioned doing this and that it would be a good idea..........??

    anyone? Thanks. BarbJL

  • Report this Comment On February 20, 2009, at 4:07 PM, justthefcts wrote:

    Mark to Market accounting - is attempting to value a long term asset in the short term- cash or cash equivalents - or the here and now no reserve auction price. Real estate and the mortgages that go with them are long term assets. Mark to market would require any lending institution to have a greater than 30% Capital ratio to stay solvent in a crises. Just like any home-owner's equity. To force banks and institutions to mark a long term asset to market to the extent of insovency when it is very probable that housing will recover over the next few years is ludicrous. Marking to market has depressed the stocks of these institutions unfairly and I believe has considerably worsened bad situation. We need to truly categorize and distinguish short term assets and long term assets and in the case of long term assets to average the value up or down according to some value index. With respect to real estate - an average over ten years of real estate values might work.

    JTF

  • Report this Comment On February 26, 2009, at 6:48 PM, HADTOBE wrote:

    I wonder what ever happened to an asset of one dollar is a one dollar asset. A debt owed of one dollar is a liability of one dollar, iff you hold one of each then, total worth, this case would be zero. All this smoke and mirrors is just that. Remember 1929, and buying on a 10% margin, lots of folks had or borrowed securities at 10% of value because they could, hoping to make a killing when the stock rose in price. When it fell, they did not have the available funds to make up what they owed to keep the loan of the stock solvent, and they lost it all. This talk of 'in ten years or so' is just more smoke. When the call is made the resources to pay must be available or we are right where we are, in trouble.

  • Report this Comment On March 13, 2009, at 11:37 AM, safarilex wrote:

    It's so easy to want to get rid of the m2m accounting as an alternative way to wish to losses away. It's so ridiculous to blame a sound accounting practice for the staggering "bank" losses.

    The reality is that m2m accounting was not intended to be applied to shadow banking practices which almost exclusively drove the securitization of subprime mortgages. m2m was intended to be applied to normal securities originating from deposit banking institutions and legitimate securities transactions. Subprime's credit swapping and leveraging is a questionable banking practice not entirely subject to the auspices of the SEC.

    If paper is not performing and cannot be sold then it should in fact be devalued. The rule of m2m does not cause it to be devalued. If the paper no longer generates cashflow for the senior ranking investor, then it should rightfully be devalued to whatever the market will bear. Hence the staggering losses.

    We should focus on the answer and stop the blame game.

  • Report this Comment On March 13, 2009, at 2:59 PM, CodyDog09 wrote:

    You have missed the point. There are pools of good loans with no missed payments and borrowers with pristine credit that are being marked down on bank balance sheets because there is no "market value" for them. A lot of these loans will continue to make payments on time until maturity, yet they have been de-valued significantly because of "m2m."

  • Report this Comment On March 18, 2009, at 7:38 PM, Battershell wrote:

    I just read Fool's comments on mark-to-market and I was so pleased to read something that refutes what the US is doing. As a result of the mark-to-market we have income statements with funny money that we have to factor out in order to find out how the organization is actually doing. There is a place for value accounting but not in the overall operation of the business. We need to get back to historical cost accounting so we can now how a company's actual operations are doing today and how we can anticipate the operations doing in the future. An additional statement (when needed) that provides the value of the business and does not filter to the income statement is appropriate. However, the way it is being used today one cannot determine if the operations are doing a good job because it is all muddied up with funny money.

  • Report this Comment On May 01, 2009, at 9:54 PM, STLrealtor wrote:

    How will this affect the accounting for properties that banks own?

  • Report this Comment On May 26, 2009, at 3:19 PM, MikeRazar wrote:

    An accounting rule has no effect on the" true" value of anything. The common fallacy in all arguments that there ought to be a single accounting rule, whther MTM or something else is that it is always made on behalf of Other People's Money". All you MTM bashers should honestly state if you would invest your OWN money on a loan whose collateral cannot be sold in the marketplace at or above the amount of the loan. Maybe an above market interest rate might entice you, but only as a gamble like buying a junk bond. Would you invest your own retirement fund?

  • Report this Comment On November 07, 2009, at 3:32 AM, landsnark wrote:

    Excuse me, but I seem to recall that when it was all go-go and heady a few years back, all the talk was about how the financial whiz kids wanted mark-to-market for ever, as it allowed the inflated bubble prices of assets to appear on their sheets. So now when it's the other side of the economic cycle, they all want MTM to be eliminated. Indeed, in almost all of the current writing on MTM, it's hard to find anyone talking about boom/bust cycle dynamics. Cmon guys, I know we love short memories and all but maybe you can still remember that fun party you had and what you insisted was wise fiscal policy back then...

  • Report this Comment On December 31, 2009, at 1:24 AM, Fool wrote:

    isnt it that MTM the cause of this world recession if not but i think it plays a certain role somewhere somehow

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