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House Panel Sets Hearing on Mark-to-Market Accounting

A House Financial Services subcomittee has scheduled a March 12 hearing on mark-to-market accounting rules -- a dry-sounding topic that likely would have a massive impact on the struggling big banks and the wider economy if it were altered.

Simply put, mark-to-market accounting rules, enforced by the SEC and the government's designated accounting oversight group, require a company to value -- or "mark" -- assets on its books based on the price they would bring if they were sold today.

In theory, mark-to-market provides good information for potential investors and prevents businesses from assigning any value they choose -- likely a higher one -- to things they own.

But mark-to-market can cripple businesses when no market for an asset exists, like now.

Big banks are struggling to survive -- shares of Citigroup, once the world's largest bank, closed at $1.02 today -- because their balance sheets are poisoned with assets for which no market exists. Chiefly, the mortgage-backed securities based on lousy mortgages. No one wants to buy them right now, so that means no market exists.

Some day, there will be a market for those securities. But until there is, banks have to account for them at fire-sale prices, and that's what's making the banks sick.

Many in financial services sector have argued for a relaxation, or temporary suspension, of mark-to-market as a way to help out the sick banks.

In theory, if banks no longer had to account for these valueless assets on their books, their balance sheets would suddenly improve and -- this is the important part -- private capital would start to flow back into the banks. Right now, an estimated $9 trillion to $10 trillion of private capital is sitting on the sidelines because it doesn't want to invest in sick companies.

Again, in theory, if mark-to-market were temporarily lifted, the big banks could get well almost overnight. (Another way to achieve this goal is the creation of a "bad bank" that would take all the toxic assets off the books of private banks and put them in one federally run bank, possibly called The Worst Bank In the World.)

The downside? If mark-to-market is lifted for good, or is made too lax, companies could create balance sheets that are pure fiction, giving potential investors zero insight into the health of companies.

So this is why, next Thursday at 10 a.m., Rep. Paul Kanjorski (D-Penn.), will convene a hearing of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises to talk about mark-to-market.

"Illiquid markets have resulted in great difficulty in valuing sizable assets," Kanjorski said in a statement. "Some have therefore complained about fair value accounting and sought to eliminate it. While companies need stability, investors still need accurate information. We therefore cannot allow for fantasy accounting that wishes away bad assets by merely concealing them.”

-- Frank Ahrens
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By Frank Ahrens  |  March 5, 2009; 6:16 PM ET
Categories:  The Ticker  | Tags: FASB, SEC, mark to market  
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Comments

When I studied financial accounting I learned that financial accounting is an exercise in creative fiction. The term "mark to market" implies that there is a market. If I hold an assent which I purchased from a single counterparty on not in a market, I would have to go around soliciting bids to determine what that asset might be worth at any given moment. As I understand it, this whole so-called banking crisis began when banks suddenly decided that some of the assets they held were worth much less on that day than they had been on the previous day. Nothing had changed except their perception. But under accounting rules it meant that banks which had been perfectly sound yesterday were now in parlous financial condition.In a way it was a self-fulfilling prophecy because it reduced confidence. But it had no immediate effect on their cash flow or their ability to meet their obligations. So there was no crisis. The "crisis" was created in the first instance by rumor, bad judgment and poor accounting rules. Instead of slavishly adhering to irrational accounting rules, wouldn't it be better if we just used a little common sense?

Posted by: tiktin | March 5, 2009 6:53 PM | Report abuse

It would seem that mark to market is a sound principle and that it is only being questioned now because of the disasterous effects of the derivative markets most especially credit default swaps.

There is not doubt in my mind that those who control the media are using credit default swaps to bet against the credit worthiness of various target financial institutions. Can I prove it. Nope. But I can read the trades and see the end results. Lehman was really no worse than others until a run happened. And it happened as soon as it was touted in the media that Lehman may not be healthy.

I don't think we should toss mark to market because it aggravates the current crisis brought on by the perfect storm of derivatives, sub-primes, oil commodity deregulation, and a super speculated and over leveraged oil and real estate markets.

Mark to market is one of the few things that we can count on for an accurate assessment of value. I do believe however that some other metric should be positioned along side of mark to market. Like projected 5, 10, 20, and 30 year estimations of real estate values. This way we could see what is the current value and the projected values based on conservative estimates in terms of growth, etc.

Posted by: garryh | March 5, 2009 8:07 PM | Report abuse

I have a subprime mortgage. I, along with many other people, am still making payments. So if I'm still making payments, how can the asset be valued at zero?

If the American Public had to abide by Mark to Market accounting, we would:

1) Need to come up with 20% of the lost value of a new car we had just purchased, in cash, the same day we drove it home from the dealer.
3) Each day we drove the car, we'd need to settle up, in cash, that same day, the difference between the car's sales price and it's used value each day we drove it.
2) Need to come up with, in cash, today, the difference between our home's current value and the value of the loan backing it.
2a) In this case, the value of the loan backing all our homes, if that loan is securitized, is zero. This means you have to come up with the entire purchase price of your home, in cash, today.
3) If you are lucky enough to have paid cash for your home, you need to come up with, in cash, today, the difference between the value when you bought it and the value it has today. (If you bought in the last 4-5 years, figure on 15-35%)
3) Need to come up with, in cash, today, the amount of all our outstanding credit card balances, if part of a securitized CDO (Collatoralized Debt Obligation).

The problem is when you start treating loans like equity and marking them to market, instead of marking them to maturity, or marking them to the discounted NPV of Future Cash flows, you're calling the loan immediately. But a loan is meant to be repaid OVER TIME. If you have to mark it to market today, then you are not allowed any time to pay it off. Thus the conundrum of Mark to Market. If I had the money, I wouldn't need the loan....

Posted by: paulperry1 | March 5, 2009 8:16 PM | Report abuse

My understanding of Marking to Market is that so far as dept instruments are concerned (bonds; bond notes; or consumer loans) or the debt instruments (bonds) backed by the expected cash flows from these loans, have in the past been marked to market only when the intent of the owning firm is to sell the debt instruments on the market ie short term assets being held for a maximum of one year. For those debt instruments that the firm intends to hold until maturity, FASB statement 91 says that the Premiums/Discounts or applicable fees and costs associated with originating a loan or other debt instrument should be amortized over the life of the debt instrument using the interest accrual method of amortization. The SOX act says that firms are to recognize FASB as the pre-eminent accounting authority. For firms that are holding debt instruments until maturity, the interest accrual method of amortizing Premiums/Discounts or Fees/Costs effectively causes the firm to book income related to the debt instrument at the actual Internal Rate of Return, that is the rate that will discount all future cash flows from the debt instrument to either the par value of the bond less the premium or plus the discount paid at the time the instrument was purchased or created (for bonds); for loans it would be the rate that discounts all future expected cash flows to the amount of principal lent on the origination date plus the origination costs less the origination fee. For thirty year mortgages, assuming no default takes place, this causes the originating bank to book income over the life of the loan at the Internal Rate of Return and prevents them from trying to book the income from origination fees or points during the period of closing. This is a good thing. If these loans are held by banks until maturity as long term assets, marking to market does not affect the balance sheet, and as long as nobody defaults on the loans, all is well.

If defaulting on these loans can be prevented by forcing firms that have financed mortgages for homes that were sold at unrealistic prices (any homes purchased in the past ten years and maybe more) to alter the terms of the mortgages such that the borrowers can continue to make payments without defaulting, and force the firms holding these currently toxic assets on their books to move them from short term assets to long term assets with the intent to hold until maturity (it is their fault they originated loans to acquire overpriced assets or purchased bonds backed by these notes) then the long term position of those firms would be more representative of their actual expected earnings. This would require a successful program to restructure all loans made for home purchases at unreasonable prices.

Posted by: SuperFred | March 5, 2009 8:46 PM | Report abuse

I don't believe you could scrap mark-to-market principles altogether. However, as a CPA I do find the mark-to-market rather rigid or absolute. 'No Market for selling it, its value zero', as a previous poster noted some value still exists due to at least some mortgagees still making timely monthly payments. problem is finding actual value for the assets other than what the market will pay. Even that number is suspect (a suckers born every minute). But the true monster in the room is the credit swap default debacle, MORE REGS PLEASE, that's exactly why AIG is too big to let it fail. Good point by the way, made by paulperry1 about marking to NPV Future Cash Flows

Posted by: Sanglant25 | March 5, 2009 9:01 PM | Report abuse

Isn't there anyone involved in the mark to market debate that has ever had any elementary engineering or electronics classes? It's rudimentary knowledge that if you want a stable system of any kind, you include a negative feedback mechanism to attenuate swings in state, rather than a positive feeback loop that amplifies changes. Yet, the current financial accounting standards apparently have enshrined a positive feedback loop as an untouchable accounting rule - if one institution has to sell an asset at a fire-sale price, everyone else has to mark to that price, thereby impairing capital, causing more fire sales of assets, which leads to even lower marks, etc.

Thank goodness the FASB is not in charge of setting standards for appliance safety, auto safety, etc. If they were, our cars would suddenly speed up upon hitting a set cruise control speed, our ovens would suddenly get much hotter upon reaching a set cooking temperature, etc. And the folks in the SEC who believe that applying this to illiquid securities makes sense - well, I can see why they didn't catch Madoff or close down Stanford Bank.

And people like this system for "transparency"? To me, as an investor, it doesn't seem like this system makes a bank balance sheet any more transparent than a system which allows a bank to impair capital when a security stops paying interest. I can make a good guess as to my "fair value" of an asset from information on its current and expected cash flow. The "transparency" of mark-to-market for illiquid securities gives me a transparent view only of how frightened in the market is, which should NOT be a basis for altering a balance sheet.

Matt

Posted by: matt1030 | March 7, 2009 1:25 AM | Report abuse

I heard a lot of comments that claim the M to M helps the investors to understand the true value of a company because their balance sheets are measured against the real time market value. What is amazing to me is why people would think the market value reflects the true value of the assets on the balance sheet if you don't sell on that particular day? For instance, during the boom years of dot.com bubble, some of the stocks went up to the absurd levels, e.g. $450 / share for Amazon. Would anybody think if you mark your balance sheet assets to market in those days, it would reflect the true value of your balance seet? Give me a break!

Posted by: xli123 | March 8, 2009 7:16 PM | Report abuse

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