Strong Arguments Can Be Made Against Mark-to-Market Accounting

One can make the case pretty easily that mark-to-market accounting has played a huge role in the deterioration of the nation’s leading banking franchises. Essentially, many banks across the country are being forced to write down the value of investment securities even if little or no loss has been, or is expected to be, incurred. Such writedowns are forcing banks to raise capital to cover losses that in many cases are never going to occur. Does that make any sense, or should banks report losses when they actually lose money? That is the key question surrounding the mark-to-market debate.

Consider the following example. Bank of New York Mellon (BK) presented at the Citi Financial Services Conference on January 28th and included the following slide in their presentation:

As you can see, the company wrote down its securities portfolio by more than $1.2 billion in the fourth quarter but based on the principal and interest payments these securities are producing, they only expect to lose about $200 million. Mark-to-market accounting rules are forcing them to take more than $1 billion in writedowns in excess of what they they believe will really be lost. Practices like this are undoubtedly putting more stress on the banking system than is necessary.

I have no problem requiring firms to write down assets before a loss is actually taken if they believe they will actually have a loss in the future. But to require them to take losses based on wildly volatile market prices (which are often inefficient in turbulent times like today) rather than the actual cash flows being generated from the securities seems like a poor way of disclosing the financial position of our banking system.

Full Disclosure: No position in BK at the time of writing, but positions may change at any time

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7 Thoughts on “Strong Arguments Can Be Made Against Mark-to-Market Accounting

  1. shepherd on February 4, 2009 at 12:29 PM said:

    If I’m not mistaken, there’s a paradox here in that when securities have so little demand that there is no market for them, oddly enough, they can be priced according to fair value using other methods (SFAS 157). So BK and others are punished for holding things that have enough of a demand to allow for mark-to-market valuation.
    The worry would be, I suppose, that some banks would play fast and loose with valuation.

  2. Few things. First, not having marked to market is bad because once you start putting bogus figures on assets then its hard to know when to stop. Anyone can buy a stock/bond/whatever at 30 bucks and say its worth 120 but we all know it is only worth what the next guy is going to pay for it. Buffett is absolutely right on this subject and thats reason enough for m2m.

    Second, the banks should have known better and maintained better business practices. Cash could have been raised for their loan losses when things were good. This whole mess started from banks loaning people money that they cant pay back. There is no excuse for that. Then on top of that there are all these side bets that take place that the banks themselves said they would post more collateral on the downgrade of the asset. As businessmen they should have known better than to agree to those clauses….ohhh well at least they were getting paid real well to take those risks.

    Third, market inefficiencies is part of the game. This is kind of the dirty little secret of the markets, ie. the fact that the markets peek and trough most of the time to excess. I swear everyone acts like a coke addicts when the markets are down but then they are up everyone is high as a kite. I for one wouldn’t have it any other way.The bottoms like this is what makes it worth investing, it separates the men from the boys. Plus, if I keep my head about me then I might just have a shot at making something out of myself.

    Funny how they prepare for one and two sigma events but cant think out far enough for a real big collapse or a really serious like 20 sigma worse case scenario.

  3. Chad Brand on February 5, 2009 at 9:52 AM said:

    I agree with #2 and #3, Ryan. On the first point though, there are methods of assigning fair value to assets other than market value, as the previous commenter pointed out. As a result, not using mark-to-market does not result in “bogus” values. It seems to me that fair value estimates based on actual cash flows are likely to be more accurate than simply using the last market price. Most of these assets don’t have liquid markets, and illiquid markets typically don’t provide reliable estimates of fair value.

  4. Ryan’s comments are very valid. Also, not only Warren Buffett, but even Jamie Dimon (JP Morgan) prefers M2M. Conservative M2M is not ideal but it is far superior to a ‘fair value’ number that can be whatever a company wants it to be, and which may have little to no relationship to its likely realistic current market value. In short, we need better clarity on current value not less. Until something more accurate is devised, keep M2M.

  5. Ok… correct me if I am wrong. What you are arguing is that if you have a level 3 asset(Anything where the price is not easily observable. Ie. loans, securities, derivatives including bonds and options on indexes…yadda yadda yadda) it should not be marked to market? Instead, they should be marked according to the models that are based on “actual cash flows being generated.” How do you take account for the future cash flows over the next 30 year life of that asset? What will the conditions like over the course of,lets say, that loan?

    Question:What if it was reversed, If I had a Level 3 asset that according to my “current cash flow” I thought added $1.24B at teh end of 30 years. Should I be able to count that as a $1.24B profit this year? next year? Year 15? or at year 30? What if the “current cash flow” varies over the course of the 30 years?

    Also, a large part of the problem is that you don’t take in account the credit derivatives that are leveraged up against these illiquid assets. Awesome. Now there are these CDO that have appeared out of air they can now be marked-to-fantasy because there is no easy way to check this derivatives value against the asset it is being derived from. Leaving you with basically the same problem only 2x leveraged.

    I guess what I am saying is that you cant have your cake and eat it too. Marked-to-market even if there is no easily approachable market is the only way to be real with ourselves in present terms…not future expectations.

  6. Chad Brand on February 5, 2009 at 6:29 PM said:

    Level 3 assets by definition have no market price, so you can’t use mark-to-market. I find it interesting that people are worried about getting rid of FAS 157 when we already have plenty of assets without a market value that are being valued on the books using certain assumptions.

    The cash flows from these assets should be booked as the cash is collected. A mortgage held on a bank’s books has no “market” price but we have no problem accounting for those. I don’t see why mortgage backed securities can’t be treated the same way. Why should packaged loans be valued differently from underwritten loans held by the bank?

    From my perch it seems that disclosure about what the banks have on their books and the cash flows they are collecting on them is more important than trying to assign a fair value to something that is being held to maturity.

    Maybe ABS should be treated just like loans. You monitor their cash flow and build credit reserves for expected future losses based on their performance. Mark to market is a new idea, but bank financial statements were perfectly fine before FAS 157 was written in 2006.

  7. shepherd on February 8, 2009 at 8:03 AM said:

    I don’t think Chad is advocating irresponsible accounting. Applying cash flow modeling to a security is not the same as saying that a stock worth $50 should be worth $100.

    Standard CDOs are not made out of air–they do have structures, rights, trustees, and sources of income. They may be a little complicated, but nowhere near as opaque or dangerous as is commonly believed.

    If a person is knowledgeable enough and takes the time, the future cash flows of these things can be reasonably modeled (and there are also other methods you can use in addition to cash flow).

    If the bank is planning on holding the CDO to maturity, then the present market value in a time of hysteria shouldn’t matter. Banks shouldn’t be forced to fail because of this.

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