Mark to Market Watch
Improve Accounting Standards, Improve the Economy
Part two of the “Providing Relief from the Crisis” series: Mark-to-market accounting did not create the financial crisis, but it made it much worse.
This is the second installment of “Providing Relief from the Crisis.” Read the first, with editor-in-chief R. Emmett Tyrrell, Jr.’s introduction, here.
Mark-to-market accounting is contributing to uncertainty in the markets, and it is leading to misdirected public perceptions. Certainly mark-to-market did not cause the financial crisis. Toxic subprime loans and excess leverage in Wall Street firms were the principal causes. But many people, including American Bankers Association members, believe that overly strict application of mark-to-market made the crisis much worse by creating a downward spiral of valuations based on prices in dysfunctional markets. Furthermore, current mark-to-market accounting is very pro-cyclical, exaggerating ups and downs. For years, during the good times, ABA argued against strict mark-to-market. During these bad times, we have pointed out the need to adjust mark-to-market to reflect the dysfunctional markets.
The misapplication of mark-to-market accounting in today’s situation, when there is no functioning market, has unnecessarily destroyed billions of dollars in capital. On a related matter, the recent action by the Securities and Exchange Commission (SEC) and Financial Accounting Standards Board (FASB) to address the concept of “Other Than Temporary Impairment” (OTTI) was very inadequate. The SEC attempted to resolve this issue, but FASB’s interpretation (FASB Staff Position 157-3) muddled it again. As a result, banks may be required to write down securities — even though there may be no threat to principal or to cash flow — because the markets are dysfunctional.
Congress and others have recognized the need to replace mark-to-market accounting. During the development of the Emergency Economic Stabilization Act of 2008, there was unprecedented debate among legislators, investors, regulators, financial institutions and others about the problems with mark-to-market accounting. As a result, the Act required the Securities and Exchange Commission, in consultation with the Federal Reserve and Treasury, to conduct a study on mark-to-market accounting standards applicable to financial institutions.
ABA believes that if an entity’s business model is based on fair value or if an instrument is held for trading purposes, market value (as a proxy for sales price) may represent the most relevant measure of how the instruments will be settled. On the other hand, the lending and investment model of banks is based on cash flows rather than market value, meaning that mark-to-market is not the most relevant measurement. If mark-to-market is overstating gains in good times and overstating losses in bad times, are we providing good information to the public about the performance of financial institutions? We think not.
Mark-to-market accounting needs to be addressed in the short-term by improving both the definition of fair value and OTTI. In the longer term, the efforts to move to fair value for all financial instruments should be abandoned, and existing rules requiring fair value should be examined to determine whether mark-to-market is appropriate. Some tough lessons have been learned in this environment regarding the lack of reliability and relevance of mark-to-market accounting, which should not be ignored.
It is important that any new standards improve financial reporting for users of financial statements. Our recommendations will achieve that and will help reduce some of the unwarranted uncertainty that exists in the markets. Accounting standards have played a significant role in the financial meltdown, and the time to repair them is now.
Letter to the Editor View all comments (19) | Leave a comment
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Bob| 12.11.08 @ 3:50PM
The real issue here is one of transparency to an average investor understands the risk of the underlying security. If you are not going to regulate certain types of investments, then financial reporting obviously needs to improve. The worst possible solution is to leave the market unregulated and highly leveraged and go back to historical accounting practices.
The problem with your argument is that while cash flow may not change, if the market value of the underlying security is significantly reduced, it become illiquid and untradeable. Then, a run on that institution will cause it to bankrupt itself.
Notes on a financial report are not sufficient to have the transparency a free market needs to operate. I cannot argue with going back to historical accounting methods if it is accompanied by appropriate regulation and reporting to increase the transparency.
Robert Arvanitis| 12.11.08 @ 4:15PM
Agree with the first comment, as far as it goes.
The issue is full disclosure. As an analyst, dDon't like the marks? Use your own. But you can only do that with sufficient information.
Information not available? Then that speaks volumes about the management, owning things on which they are unable to report.
Back in the 1980s, we recovered relatively fast from the LDC lending crisis, because everyone knew how much bank A lend to country X.
Economists cannot claim markets are efficient, yet at the same time say MtM matters. That is as foolish as the old arguments over pooling accounting for M&A;.
Markets are sufficiently efficient that if some are misled by pro-cyclical MtM, then a few others will exploit their ignorance and fear.
The true unknown, the real risk, is government floundering. That's what has crippled loosening.
To revert to an 19th Century analogy: Got a logjam? Dynamite - lose a few logs, save all the rest.
jr| 12.11.08 @ 5:49PM
The market as known to the above average American is a stock for which there is a value paid at the outset. The real market - that where the billions are gambled every day is the hidden market and is that which helped bring down the country's finances. When oil speculators were being talked about, the price started coming down. It was terribly inflated because of gambling. Still do not know the value of sub-primes and who really owns them -- smoke and mirrors -- and gambling.
jr| 12.11.08 @ 5:57PM
Sorry to post again but should have read the Princeton story first -by Neal Freeman. It is a perfect illustration of my point that the market has become littlle more than a gambling process for people and institutions will lots of money. Princeton was/is loaded with gambling tickets in the nature of hedge funds and other bets. 70% of its portfolio is illiquid. Can you alumni spare a dime?
RT| 12.16.08 @ 7:39PM
So many articles and comments regarding accounting standards reach the conclusion that "repair" or "improvements" are necessary. How do such changes in standards fit in with the "convergance" of U.S. GAAP and International Standards that the SEC is rushing forward with? Once IFRS are adopted, how difficult will it be to continue repairing or improving standards? The image I have of standards today and standards ten years from now is that of an hourglass with an extensive array of current standards that could become even broader - followed by the severe contraction to International Standards - and ending with stymied attempts to go back to more comprehensive standards when a new crisis develops.
table basse | 11.26.10 @ 3:15PM
Totally agree with you, RT. Thanks for this article!
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