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.