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:

Company

Assets

Financial Leverage

Citigroup

$2.2 trillion

19.3

Goldman Sachs (NYSE: GS  )

$1.1 trillion

26.2

Merrill Lynch

$1 trillion

31.9

Lehman Brothers

$691 billion

30.7

Bear Stearns

$395 billion

33.5

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 Coca-Cola Company and Wal-Mart Stores are Motley Fool Inside Value recommendations. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Matt Koppenheffer owns shares of Bank of America, but does not own shares of any of the other companies mentioned. The Fool's disclosure policy has never once been caught with its pants down. Of course, it doesn't actually wear pants...


Read/Post Comments (7) | Recommend This Article (13)

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 March 12, 2009, at 4:10 PM, pondee619 wrote:

    Could you name a financial institution, which was competitive at the time, of similar size to those mentioned, that had a more reasonable financial leverage?

    Yes, Mom, when ALL the other kids are jumping off the bridge, I am too. Unless I'm the class outcast that no one talks to. Unless the local Cop (or Mom) happens by and puts an end to the foolishness. Where were all the Cops/Moms?

  • Report this Comment On March 12, 2009, at 4:20 PM, TMFKopp wrote:

    "Where were all the Cops/Moms?"

    Good question.

    "Could you name a financial institution, which was competitive at the time, of similar size to those mentioned, that had a more reasonable financial leverage?"

    Comparatively speaking, JPMorgan, Bank of America, and Wells Fargo were all more reasonably leveraged compared to the companies in the chart above. Of course a couple of these (they know who they are) rushed to buy those over-leveraged companies when they got in trouble. One of these (it knows who it is) even payed a pretty handsome price for one of those over-leveraged firms.

  • Report this Comment On March 12, 2009, at 5:50 PM, jasonjim wrote:

    Motley Fool says mark to market when a market exists. The problem is, which seems to escape Motley Fool, is that no market exists, or no market which is willing to pay anything but fire sale prices for any assets offered. Disappointing article which does nothing to try and get us out of this crisis---are Motley Fools shorters?

  • Report this Comment On March 12, 2009, at 7:42 PM, TMFKopp wrote:

    "Motley Fool says mark to market when a market exists."

    First thing I should point out is that The Motley Fool doesn't say anything here about mark-to-market. The article above is my opinion on the situation and it's very likely that other folks at TMF disagree with me.

    "Disappointing article which does nothing to try and get us out of this crisis"

    I'm interested in a sustainable recovery, not one that is based on financial companies' sudden ability to once again ignore market prices for their assets. Lowering financial company leverage and taking a sober look at what kinds of assets should be held in our banking system seem like solid steps.

  • Report this Comment On March 13, 2009, at 6:39 AM, VenetianPoker wrote:

    "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."

    Not quite. It's actually a little worse.

    If I have $1 in equity capital and leverage it 2:1 with debt, I can buy a $3 asset. If that asset's value falls by 33% (as opposed to 50%) in value, my capital is wiped out.

    Comparing financial firms to the likes of Coca Cola and Walmart also doesn't make a lot of sense with respect to leverage. Different industries will always have different capital structures and balance sheets.

    As for mark-to-market, it's one thing to require that companies have the true value of their assets represented...it's another thing to ensure that those valuations are accurate. As long as there is doubt about the valuations, you really can't support requiring the use of that valuation in deciding whether a bank is solvent.

  • Report this Comment On March 13, 2009, at 10:34 PM, jerryguru69 wrote:

    Disagree in the strongest possible terms. The author is making the classic mistake of mixing apples and orange.

    OK, let us talk about leverage. 2:1, 5:1, 10:1, 30:1. This is definitely an argument we can have. What type of financial institution are you, and how much leverage should you be allowed to have, based on prospectus to investors?

    Now, the GAAP principle on the carrying value of Level 3 securities on your books is WAY different. Say you are 10 years away from retirement, so buy a US Treasury Bond maturing in 10 years. After 5 years, interest rates go up, and the “mark-to-market” value of your bond goes down: so, under current GAAP rules, you are obligated to either raise more funds or delay retirement, or declare insolvency.

    Tell me: does this make sense? The author’s arguments are quite valid, but only for Level 1 securities where you can just pick up the newspaper and get an exact value. You have a vial of “genuine” Elvis Presley sweat: what is it worth: only what is quoted in the WSJ?

  • Report this Comment On March 15, 2009, at 3:31 AM, MrZ2357 wrote:

    The problem with M2M is not that it is a bad idea, the problem is that the assigned price to illiquid assets is wrong.

    In an illiquid market prices tend to be volatile and can be manipulated. In this case the "fair value" assigned to the asset (what its trading at) can be unrelated to its true value.

    For assets that generate cash flow, a value based on that cash flow should to be incorporated in the determination of the asset's value and not just what it is trading at.

    Z.

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