To Mark-to-Market, or Not to Mark-to-Market?

As investors and traders keep trying to figure out whether the market has bottomed, or whether Citigroup's (NYSE:C) health report holds any truth, one question seems to pop up over and over again: Should we jettison mark-to-market accounting?

The assumption is that forcing companies to mark their investments to markets that are under significant pressure, or downright frozen, helped exacerbate the panic that has engulfed Wall Street for more than a year now. Opponents of mark-to-market accounting believe that if banks and other financial institutions weren't forced to mark down their assets, there wouldn't be the dire concerns over liquidity that pushed Lehman Brothers over the precipice and into bankruptcy, and forced Bank of America (NYSE:BAC), Citigroup, and JPMorgan (NYSE:JPM) to take billions in government money.

But worrying about mark-to-market lets a bigger issue slide.

Leveraged into oblivion
Mark-to-market certainly played its part, but the only reason it had such a catastrophic impact was because of the massive leverage employed at the major financial institutions. Had banks and brokerages used only a moderate amount of leverage, marking down assets wouldn't be nearly as big of a deal. Sure, the firms' book values would still fall, but it's less likely that those markdowns would imperil them.

As we increase the leverage on a firm's balance sheet, though, ever smaller losses can start to put it at risk of failing. Lever it up 2-to-1, and assets would have to decline 50% to wipe out the firm's net worth. Lever it up 3-to-1, and it takes a 33% drop to leave the company grasping at straws. Put leverage at 10-to-1, and it only takes a 10% hit to assets to get to the same end. Of course, 10-to-1 leverage was on the low end of what financial firms were doing. Here's a look at where some of the major financials stood when their 2007 fiscal years ended:

Source: Capital IQ, a Standard & Poor's company. All numbers are as of fiscal year end 2007.

For sake of comparison, Coca-Cola was leveraged 2-to-1 at the end of 2007, Halliburton was at 1.9-to-1, and Wal-Mart (NYSE:WMT) clocked in at 2.5-to-1. Of course, we can also note here that the danger of leverage is certainly not industry-specific. Lately, we've been treated to the tribulations of the U.S. automakers, but we shouldn't have been surprised -- Ford (NYSE:F) had an amazing 50-to-1 leverage at the end of 2007, and as for General Motors (NYSE:GM), well, the last time it didn't have a negative book value was in 2005, when it was leveraged 32-to-1.

The answer to mark-to-market
Even if mark-to-market isn't the right question right now, there's still an answer to it: It needs to be kept in place. Turn to any accounting book, and you'll see that the purpose of a balance sheet is to provide a picture of the company's assets and liabilities at a point in time. If financial institutions want to give investors additional disclosure showing them what management thinks its assets are worth, that's great. But for a balance sheet to be a worthwhile measure, we need to be marking assets to market when markets exist.

Keeping mark-to-market in place has the added benefit of discouraging financial companies from stacking up similar levels of leverage in the future. If they have to prepare their balance sheets for potential adverse market movements -- as opposed to the placid stability of a given company's valuation models -- then 30-to-1 leverage suddenly sounds a little less appealing.

There's no doubt in my mind that the debate will rage on over whether mark-to-market should be pulled, and the opponents of the convention may even come out on top. But investors who want to avoid buying into stars destined to become supernovas need to keep in mind that massive leverage, not mark-to-market accounting, was the real seed that grew into financial disaster.

Further financial Foolishness:

• The Biggest Bubble the World Has Ever Seen
• Who Should Go to Jail?
• It's Time to Sell and Walk Away