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The Folly of Mark-to-Market

Ralph Katz       March 17, 2009

Mark-to-Market accounting may not be the cause of our financial problems but it made everything worse. FAS Statement #157 states that financial assets of a company should reflect the market value of each holding. In theory, this concept has some merit. Of course, the first European missionaries who went to South America probably also thought they were going to do good (instead of spreading a deadly plague for which the locals had no immune defenses). In practice, Mark to Market has come under increasing fire the past year for many valid reasons.

The Statement went into effect in late 2007 just as America’s financial crisis was starting to emerge. Suppose a bank holds an asset that is performing at a good level. If someone else sells a similar asset in a “fire sale” situation, accountants mark down the values on the books of everyone – thus creating a very low artificial price. So what? The bank can just hold on to the performing asset.

There is a problem. Since banks are required to hold specified levels of regulatory capital, any marked down asset appears as a current earnings loss and the capital must be replaced. Since the market aggressively sells any bank that is low on capital, the bank has to raise new funds at the worst prices. Potential investors also know there could be a further write down. It is a vicious circle.

As someone who has traded for my entire professional life, I believe in markets – but only when they are real markets. We all know what happens when trading is not liquid. Spreads widen and prices are inaccurate. I always like to look at real data. Tom Brown at www.bankstocks.com has a great example ( http://www.bankstocks.com/ArticleViewer.aspx?ArticleID=5701&ArticleTypeID=2) using an actual 10-K from Capital One. The company is well capitalized and solvent according to GAAP, but simultaneously insolvent from the point of view of many market participants. Obviously, this makes no sense.

One of the paradoxes of Mark to Market is that issuers of bond debt can show gains in cases in which the value of their offerings has decreased! Since bond debt is a liability of the issuer, a reduction in said liability has the impact of increasing shareholder equity when the bond’s liability value is written down – not a rational result. In 2007, this phenomenon resulted in many companies to record added billions in gains. Among those reflecting such gains was the first financial kingpin to fall in America’s financial crisis -- Bear Stearns. The law of unintended consequences struck again with a vengeance. Mark to Market clearly amplifies the “boom bust” cycle of asset values.

Let’s not castigate the accountants any more than those European missionaries. Well, maybe a little, since there often is a significant increase in compliance costs. But Mark to Market needs to be fixed.
Ralph Katz Burr Ridge, IL

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