So, mark-to-market accounting contributes both to credit bubbles, which no one on Wall Street ever complains about because they are too busy raking in the cash, and credit busts, at which point, Something Must Be Done.
There's just one big fat honking problem. If mark-to-market rules are suspended, what replaces them? Surely we don't trust the owners of these risky assets to decide for themselves what they're worth?
From the SEC's "Clarifications on Fair Value Accounting," released Sept. 30:
Can management's internal assumptions (e.g., expected cash flows) be used to measure fair value when relevant market evidence does not exist?
Yes. When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable.
Internal assumptions! Never mind what the market says, we'll just trust you to figure it out for yourselves, boys, because we know you would have no reason to lie about something as immaterial as the state of your own finances!
The attempt by members of both parties to suspend "fair value" accounting is outrageous. Despite Republican claims to the contrary, the United States is not facing a severe financial crisis because of accounting issues. The crisis was created by investors who made huge bets with borrowed money on risky loans and complex derivatives that they did not understand and that blew up in their face when the housing market collapsed. The crisis was created by greedy fools who blithely sold insurance against the possibility of anything bad happening to these securities, without ever dreaming that they might actually have to pay up. The crisis was created by politicians who explicitly made sure that these bond-default insurance policies -- credit default swaps -- were unregulated.
Don't blame the accountants. Listen to them: (Compiled by Calculated Risk.)
"Suspending mark-to-market accounting, in essence, suspends reality." -- Beth Brooke, global vice chair at Ernst & Young LLP, WSJ, Sept 30, 2008
"Blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick." -- analyst Dane Mott, JPMorgan Chase & Co., Bloomberg
"Suspending the mark-to-market prices is the most irresponsible thing to do. Accounting does not make corporate earnings or balance sheets more volatile. Accounting just increases the transparency of volatility in earnings." -- Diane Garnick, Invesco Ltd., Bloomberg
The just released draft of the Senate bailout bill, a 451-page monstrosity, includes a provision expressly giving the SEC authority to suspend mark-to-market accounting.
I think that Leonard is right, in that suspending mark-to-market accounting is fairly insane. But I think he's wrong to short-shrift the very real problems with it.
For those who are perhaps not familiar with mark-to-market accounting, the basic idea is that you have to price the assets on your balance sheet at their market value, not at what you think they're worth. This rule is a result of the Enron crisis; it was intended to keep companies from misrepresenting the assets on their balance sheet to the point of bankruptcy.
But it does create real problems in an illiquid market. As Alan Blinder, channeled through Matthew Yglesias, explains:
The idea of mark-to-market accounting is that when you're reporting your balance sheet -- your assets and your liabilities -- you need to report the value of your alleged assets at what you could actually get for them on the market. In a normal highly liquid market, this is easy and non-problematic. But as Blinder says, in an illiquid and non-functioning market, as we currently have for our "troubled" assets, you get into trouble. Specifically, you get these huge spreads between the bid price and the ask price for the assets and no actual sales happening. Blinder's example is that if the highest bid is $20 and the lowest bid is $60, where do you value the asset? Thus, "there are legitimate problems that need some attention in how you apply mark-to-market accounting when markets aren't functioning."
The other problem is that in an illiquid market such as ours, where the risk premium on some assets has gone so irrationally high that they basically have no market value, revaluing those assets is not actually a fair estimate of what they're worth. Beth Brooke says suspending these rules "suspends reality", but what is reality? Is it what you could sell the asset for today, or the expected future cash flow? In a rational market, those things are supposed to track fairly closely. In the current market, they clearly arent'. Which "reality" should we choose?
The first principle of accounting is to be "conservative", that is, to give executives as little room to play with the numbers as possible. For that reason, I agree with Ms. Brooke that it's a bad idea to suspend these rules, much less abolish them. But Leonard is dead wrong when he says "the United States is not facing a severe financial crisis because of
accounting issues" and blames the problem exclusively on greed and deregulation.
This crisis is so huge and complex that I don't think you can fairly cite anything as the main cause. But it is certain that the way we account for securities has contributed, by turning illiquidity in various banks into insolvency. Moreover, while deregulation played a role, so has regulation. One of the reasons that severe markdowns are such a problem for banks is that the thin balance sheet triggers a ratings downgrade. At that point, many large institutions are legally prohibited from investing in them; others are forbidden by charter. The change in the government sanctioned rating kicks in government rules which ensure that bankruptcy rapidly follows a writedown. Did I mention that financial firms are not allowed to restructure in bankruptcy? They have to liquidate.
Here's the thing: to say that government regulations have contributed does not mean that those government regulations are a bad idea. Mark-to-market accounting is a good idea. So are stringent limits on what types of securities pension funds and insurers can invest in. Requiring companies to open their books to ratings agencies is a good idea, though I don't think the SEC-enforced monopoly of the big three was so grand. There is probably a decent argument for the rules about broker-dealer bankruptcies, though I don't know enough about that particular area of bankruptcy law to say.
Good rules can produce bad results. They can produce bad results simply because there is no such thing as a perfect rule, and with the abovementioned regulations, I think we're just going to have to live with their imperfections. We are not going to find a flawless solution that will prevent any further problems in the financial markets without creating any other problems; you cannot make an omelette without breaking eggs.
There is one aspect I think we could and should address, however, and that's our basically piecemeal approach to enacting regulations. Sarbanes-Oxley solved the last crisis, but didn't look towards any future ones it might be helping to create. That's how financial regulation always is in this country (and probably most others); whatever problem we just had is the only problem worth solving. Just as banks were looking only at individual securities, not the systemic risk of the way other market players were investing, regulators looked at each piece of the puzzle, rather than assessing how all the pieces fit together. Had they done so, we might have had time to come up with some way to alleviate the regulatory issues that have exacerbated this crisis (though we might not have, either--I certainly can't think of any off the top of my head).
Instead, we're flailing. Mark-to-market is causing problems? Suspend it! What about Enron? WHY ARE YOU TALKING ABOUT ENRON?! WE'RE HAVING A CRISIS!
Yes, we sure are. Maybe that's because every time we have a crisis, we have that same damn conversation.
Securities law is a highly entertaining mismash of statutes, rules and regulations promulgated pursuant to statute, and commentaries and explanations of those rules and regulations which, although lacking the force of law, are generally take as law. The number of exceptions exceeds the number of rules, and elaborate highrises of jurisprudence are built on the slimmest of foundations (such as Rule 10b-5, which basically says "don't be bad.")
It's worse than tax law. Way worse.
It seems like there was a whole lot more wrong with Enron than mark to market accounting though maybe the latter would have prevented it. Historically I understand English accounting is said to necessitate adherence to a accepted list of general principles and you could be docked for not doing that but were allowed some leeway in how you developed your accounting plan whereas the American idea was to make lying as near as possible impossible because every detail flows from a rule. Part of our trouble may be the sense that, having (exhausted ourselves) following the rules we are not "liars," so not to worry. Moody's says it's AAA etc, Fannie Mae etc. A friend tells me there were $3 trillion in mortgages authorized over the last two years bundled and sold, in part, to that bank acting like it took cyanide. #1 trilion was authorized in 2001. All seriousness aside, 'Look up in the sky. It's a bird; it's a plane. No, it's Superdebit: Barney Frank and a friend wearing their capes in their tight swimming pants.'
Mark to Market appears (to my limited understanding) to be a major factor in the current mess mostly because it is done daily. If assets didn't have to be marked to market more often than yearly, it would still prevent keeping devalued assets on the books forever at purchase price, but avoid the abrupt downward spiral we see today.
And, while we are fixing things, when will someone notice that part of the problem is "off balance sheet" vehicles which suddenly come back onto the books at the worst possible moment. Can someone explain why something can be not shown on the books but still the responsibility of the company? If there is a solid accounting reason to allow that, I have not come across it -- but then, I'm not an accountant. Maybe someone here has an idea.
Perhaps we ought to allow firms to choose which method to employ, with a disclosure requirement. Firms opting for m2m would likely be rewarded by investors in the long run. And I second the call for principles over rules.
Megan, I hope that I'm not pulling a Sarah Pallin here and that I address your points about mark-to-market accounting. Insofar as the SEC requires public companies to mark-to-market difficult to value securities for financial reporting purposes, there is no reason why these public companies cannot also provide, for example in the management's discussion and analysis section, alternative valuations based on different assumptions. (In fact, that's the whole point of MD&A--to explicate the financials in plain english and to give investors insight into what managment makes of the reporting company's financial statements and results of operations).
Margin requirements and margin calls based on mark-to-market accounting makes sense too. As a creditor taking collateral (and as a borrower offering collateral), it seems crucial that you derive the benefit of your bargain and remain adequately protected. Eliminating mark-to-market accounting whole-sale erodes this. It seems to me that most creditors would, as a result, require even more collateral given the uncertainty of valuation without mark-to-market accounting.
@Rob Lyman, I am a securities lawyer. I see nothing wrong with vague rules and what is, in essence, a "common law" of securities regulation. The federal securities laws and rules are intentionally vague in many areas. Why? Because when you have precise rules, highly paid lawyers such as my colleagues will figure out a way to get around them. And what happens when people get around rules? More rules result because the government ends up filling loopholes. There simply is no way around this--to expect that people (especially people acting in their or their firm's own self interest) would act any differently defies experience. As an anti-fraud device (and that is principally the purpose of the entire body federal securities laws), it makes far more sense to say "don't be bad (but we'll make some exceptions based on experience [and lobbying])".
I referenced federal "common law" for a reason. If the common law worked in England for so long, I see no reason why it wouldn't work with respect to things like forbidding fraud on the markets. (Yes, I realize that no one really knows what that means, but if you have to ask whether something is fraudulent, you're already starting to tread on dangerous ground). A good analogy is to murder. Of course the law says that killing someone is illegal, but it turns out that this isn't always true. Killing someone in self-defense may be excused if the killer didn't understand the consequences of his/her actions; it might be justified in self-defense; etc.
Finally, if you start with the principal that no person or group of people can make a perfect law (i.e. a law that can't be circumvented), then the way that the securities laws are drafted makes sense. They are intentionally over-broad, and the statutes generally provide the SEC with rule-making authority to make specific exceptions, mostly because otherwise, people will work around these rules and further action would require Congressional authority (political will that might not otherwise be available).
As a more precise example, section 5 of the securities act of 1933 provides that a prospectus must be used any time a security is sold by means of interstate commerce. It turns out that most people who sell securities don't end up using prospectuses because there is an exception for people who are not acting as brokers, dealers or underwriters (all these terms have technical definitions).
(I note, as an aside, that
In response to Rob Lyman and future commenters (I'm sure that there will be many with respect to the issue of rules and regulations promulgated by the government), a big problem is that generally speaking, people will tend to shade their actions to what is to their advantage.
I stated this before in another blog. My main complaint about Mark-to-Market accounting is that it looks like it causes a positive feedback loop. Once the price of an asset starts moving down, mark-to-market accounting forces a company to offload some or all of the asset before it takes them below some threshold level of asset requirements.
As soon as one company starts selling an asset and driving the price down, other companies using mark-to-market accounting will start selling that asset, driving the price down further.
Meanwhile, on the other side, firms will start buying a different asset to replace the one they just sold. They'll look for an asset that rising in value, and start dumping money into that, which will attract other buyer, driving the price up higher and higher.
On either type of price run, up or down, the prices will keep moving until the mark-to-market firms are completely out or in, or the price rises or falls to an irresistible level for the rest of the market, or the market breaks completely. Positive feedback loops make for wild fluctuations in prices.
The solution I support is to state both Mark-to-Market and Best-Estimate figures side by side in the reports. Let the interested parties decide for themselves how much weight to assign each.
I think the best solution is not to suspend mark-to-market rules but to value the securities on a three month (or similar) average rather than daily price. Pension funds used the same basic approach; it allows you to quote realistic prices without leaving you vulnerable to sudden swings.
I see nothing wrong with vague rules and what is, in essence, a "common law" of securities regulation.
Yes, well, I'm an IP lawyer, and I see nothing wrong with using undefinable words like "famous" in trademark law. People who get paid by the hour to write opinion letters rarely see anything wrong with vague rules.
As a more precise example, section 5 of the securities act of 1933 provides that a prospectus must be used any time a security is sold by means of interstate commerce.
The rules surrounding prospectuses would be Exhibit A to my indictment of the securities laws. They have been created ad-hoc as information technology evolved and are (or at least, were until a couple of years ago; I'm not up to date) extraordinarily confusing.
The problem with securities law being built of vague rules and evolving like the common law is that you're supposed to have some idea of what is allowed and what is forbidden in advance. When the common law was being formed, you at least had the Bible for guidance, and most of the rules came out pretty much as a decent person would have liked. But neither the Bible nor reference to decency can tell you what a free-writing prospectus is, and whether or not you can safely let the public see it on your website this week. Yet upon such questions, jail time and billion-dollar lawsuits hang.
UNIFIEDMARKETS provides true price discovery in all types of assets.
I think we should just "suspend" all public accounting. It's expensive and it interferes with the ability of some people to continue to get their $90 million/yr salaries and pay dividends.
What's worse, it only inspires GOP appointees like Cox.
While we are at it, we should suspend "securities law". It really is bothersome. We ought just let the biggest people fight it out however and realize that, from time to time, Free Market Capitalism means that everyone gets a nice, cold, long, douche courtesy of "management", whoever they may be and however they came to their responsibilities.
If you aren't up for the real medicine, I suppose that the worst part of "suspension" is that it puts valuation in the hands of the sinners. It would have been better to have come up with a way to have independent valuations rendered. It would have been wise to narrow the exception to a class of securities, too, and to make full disclosure of valuation assumptions, etc.
Now that we've suspending things in the world-according-to-Cox, the next "investigation" we'll have is of the accounting firm that was willing to sign-off on marks that were ... fantasy.
Why not report values of assets as a RANGE rather than a single value? My treasury bill is worth somewhere between $9995 and $10005. My house might be worth somewhere between $100,000 and $400,000. Why not simply report it that way?
Yes, sometimes values of assets move in opposite directions, so a provision for offsetting the ranges might be necessary.
I guess then on the balance sheet you would have to report the equity also as a range as well.
Maybe it's an odd proposal, but maybe no worse than what we have now.
Mario is correct about reforming mark-to-market to a rolling average to smooth out wild swings in valuation. I would think, actually, that the period over which the moving average is taken should be a bit longer, say twelve months. Some have suggested as much as three years or longer, but that seems a bit much. Even at twelve months, that rolling average can be longer than the maturity of some of the assets being valued.
The only thing that still isn't really resolved though is: What market value is entered for this rolling average when the market is completely illiquid? The value isn't low or zero, it's undefined. Conservatively, you could go with the bid even if it's way below the ask.
Even with the smoothing, in a prolonged period of illiquidity, you still get the same problem. But, the hope is that while preventing illiquidity from turning to insolvency overnight, one could prevent periods of illiquidity from lingering too dangerously long. Twelve months of smoothing should be long enough for people's heads to cool. Three is not enough, and thirty-six hides true valuation to an extent that the name "mark-to-market" practically becomes a misnomer.
It should not be surprising that stability of systems with feedback from output to input is well understood in engineering. As noted in comments above, the first defense against instability is a loop integrator or low pass filter, i.e. averaging over time. This integration suppresses high frequency signals from causing spurious response, but simultaneously introduces a lag or phase shift which makes snappy decision making (control) difficult. If you substitute long term (integrated) estimates for real time posted data, you gain stability but lose speed in responding to trouble. After Enron, it was all about getting the system to respond more quickly to trouble, but decreased stability margin is the yin for that yang.
There is another aspect of mark-to-market that makes it highly unstable in the presence of non-functioning markets, let's call it mark-to-market risk.
Normally when a financial institution is evaluating purchasing an asset, they need to be aware of various 'real' risks to of loss: default risk, prepayment risk, risk of devaluation of the collateral, etc.
But if I am an institution subject to capital requirements and mark-to-market regulation, I also have to consider the risk that the market undervalue the asset and thus put me at risk to missing my capital requirements even if the underlying asset itself is still performing admirably (aka, making me money hand over fist into the sunset) at the price I bough for.
I would maintain that it is this mark-to-market risk is the what is driving this situation from a *really* down year (think the market crash in 2001) to an absolute financial panic. Even if there are *complete* steals out there to be had, and financial institutions with cash to buy them up and make a killing on the 2-3 year time horizon, none of those institutions can afford to do so because of the mark-to-market risk on the two month time horizon.
There is another aspect of mark-to-market that makes it highly unstable in the presence of non-functioning markets, let's call it mark-to-market risk.
Normally when a financial institution is evaluating purchasing an asset, they need to be aware of various 'real' risks to of loss: default risk, prepayment risk, risk of devaluation of the collateral, etc.
But if I am an institution subject to capital requirements and mark-to-market regulation, I also have to consider the risk that the market undervalue the asset and thus put me at risk to missing my capital requirements even if the underlying asset itself is still performing admirably (aka, making me money hand over fist into the sunset) at the price I bough for.
I would maintain that it is this mark-to-market risk is the what is driving this situation from a *really* down year (think the market crash in 2001) to an absolute financial panic. Even if there are *complete* steals out there to be had, and financial institutions with cash to buy them up and make a killing on the 2-3 year time horizon, none of those institutions can afford to do so because of the mark-to-market risk on the two month time horizon.
Could you square this for me with EMH? It is a question I have been confronting a lot lately - if the assets really are worth more than what people can get for them today, why aren't the people with money snapping them up? Is it because the banks are holding out for a better price? I find it hard to believe that that is the complete answer when the other option for banks right now is to go belly-up.
Sarbanes-Oxley solved the last crisis, but didn't look towards any future ones it might be helping to create.
Down the road, SOx is going to be the key contributing factor in the "next big crisis."
There's a lot of good ideas in that legislation, but it's also increasing the cost of doing business by millions of dollars in up-front, into-compliance money--all the restructuring, all the money that goes to personnel that essentially sort and document a lot of mundane, not-particularly-relevant crap in an overly rigid format...all the highly-paid superconsultants that are needed to explain the labyrinthian nature of SOx compliance. You wouldn't believe the cost of the bare minimums for compliance in IT infrastructure.
Because of all this, getting into SOx compliance usually requires a lot of loans.
Add in the fact that the majority of start-ups eventually knuckle under and, well, you get the picture.
Maybe I'm wrong, but, even so, I see SOx as pretty unsustainable in its current form.
Upon reflection it occurs to me that much of what made (and makes) the vague, evolutionary common law work is that juries have the experience necessary to make judgment calls. That is not true in a securities regulation context.
We can use a wishy-washy standard like "reasonably prudent person" for auto accidents because most jurors are drivers and have a good sense of the difference between safe driving and reckless driving. Even in a complicated medmal case, experts witnesses can explain what doctors do in a way that jurors can appreciate; they have some experience with doctors and illness, and so they can ground the testimony in their own experience.
But no jurors can tell what a "reasonably honest accountant" would do with a particular security, and the battle of the experts is so much gobbledygook (this can be a problem in patent cases, too; claim construction is not for amatuers, and federal judges, who are not fools, often get it wrong).
So we cannot expect the civil justice system to deal with vague standards well in securities law.
Are there really securities for which the "expected future cash flow" is worth much more than the current market price? "Expected" by whom?
I can't believe what I'm hearing...blaming accounting regs for our economic crisis. That's like going to the doctor and blaming him for a diagnosis. Unless you want a balance sheet out of some fairy tale, mtm accounting is the only objective measure of an asset's true worth.
bc, that's a fine point about the potential for a smoothing function to cause a lag in decision-making. However, just because you assess assets on your books with a smoothing function to prevent insolvency dosen't mean that you can't keep track of their real-time market values in parallel to inform business decisions. This can be done in the same way that P&L is kept different from cash flow figures. Amortization is a sage, widely accepted practice, but it sure doesn't help if your cash flow prevents you from making payroll on time.
Mark To Make Believe is the only sensible option.
That's just the thing we need to restore confidence.
For myself I will be paying my bills this month with invisible checks.
I can't believe what I'm hearing...blaming accounting regs for our economic crisis. That's like going to the doctor and blaming him for a diagnosis. Unless you want a balance sheet out of some fairy tale, mtm accounting is the only objective measure of an asset's true worth.
Yeah, but if you received a clean bill of health and someone informed you that you still needed to go back to the doctor every day for a fresh diagnosis, you might hand that person auger-type hardware fastening device and a spherical sporting-goods toy, and suggest they contemplate the meaning. A metric that can essentially track the noise in the market and begin sending misleading signals as a result is giving too much data.
If MTM is meant to be viable accounting method, monthly or quarterly adjustments ought to be more than sufficient for a majority of asset types.
Not having a pleasure of being either an accountant or a securities lawyer, I would like to make this a layman’s contribution, and I will certainly appreciate any professional comments.
There’s no surprise that the idea of suspending mark-to-market accounting valuations with the so-called internal assumptions caused outrage among many finance and accounting professionals.
Saying “anything goes” is by far the worst response to the problem. I may sound awfully old-fashioned, but there’s another alternative to mark-to market beside the “internal assumptions”, which, I agree, are hardly an alternative at all. To dispense with the notion of internal assumptions, the quote from the SEC Press release is the most illuminating source:
I guess the key problem for me in the whole approach is the idea of “appropriate risk”. I was taught that it does not exist, because every market agent has a unique risk preference curve, i.e., everybody finds their own levels of appropriate risk that would be entirely inappropriate for the rest of the world. Megan and Andrew Leonard find lots of other problems with this approach, and I am not going to disagree with them.
Then, going back to the mark-to-market methodology, I tend to agree with Megan and many others who previously agreed on the fact that mark-to-market tends to create loops and self-fulfilling prophecies. When the times are good, your flourish beyond your wildest dreams and, I may add, beyond what you deserve… Rising tide lifts all boats. When the times are bad, you may be the most prudent entity left in the market, but if you hold any instruments that may be traded in the market, they are going to drag you down like the worst devil scare of an Evangelical preacher. The situation is, indeed, particularly bad in case of financial institutions, which must meet a separate set of capitalization standards imposed by the Federal banking regulations. As their marked-to-market assets take a hit from the market, they become subject to additional capital requirements and, simultaneously, subjects to restrictions on investments from other institutions. As a result, any solution to the problem at hand, such as the sale of devalued assets, increase in capital ratio, and others, tend to either exacerbate the state of the market or the financial standing of an institution itself, directly through immediate changes in its balance sheet or indirectly through its ability to conduct its business. So, it is fair to blame mark-to-market for contributing a great degree of difficulty in this financial crisis.
Now, prior to Enron and Sarbanes-Oaxley, they used to teach two accounting subjects in B-schools – managerial accounting and financial accounting. The two were different in respect to the treatment of market value and book value of the assets. In layman’s terms, managerial accounting dealt with record keeping, while financial accounting valued equities and concerned itself with reporting to outsiders. Incidentally, a 1997 managerial accounting text-book by Dale Morse happened to be on my bookshelf, and it clearly specifies the use of historical cost to measure the value of assets of the organization, prescribing the use of historical costs, or book value, until the market value is recognized when the asset is sold. It goes further to say that an advantage of using historical costs is their objective nature. Prior to 1975 cost basis was the norm in the US, from 1975 through 1993, equities on the balance sheet began to be reported on the lower-of-cost-or-market basis. From 1993 we were in the near total mark-to-market environment, including debt instruments, that nourished today’s mess.
Of course, returning to cost basis would deprive institutions of great many trading opportunities, not to mention that it would lead to certain tax implications, reduction of performance bonuses, and, as legitimate critique may go, a great loss of transparency, too. Of these factors, only the last one really matters. However, it can be very easily addressed by using the mark-to-market approach in traders’ assessment of the value of traded stock in an institution rather than valuing its assets. A very simple, if not simplistic guess would be that many institutions, especially in the financial sector, would have had a very strong incentive to be a lot more careful with their investments, if it had a direct implication on the value of their stock without exposing them to the grinder of financial regulators as far as the banking rules are concerned. After all, losing the share price while maintaining a strong asset base is a sure way to become a target of an acquisition. That would certainly make great many CEO’s think twice and thrice before stretching the limits of “appropriate risk”. Once again, this is a simplistic layman’s approach, but would not we be in a better spot today, if this were the case?
Hi -
Xmas and Irreverent Comment are right: mark to market is a severe error because it is procyclical.
The business cycle isn't dead. Adding a procyclical component to the business cycle, one that determines the "true" value of any company, is something that only those who have absolutely no idea about how the economy works and the nature of business cycles could think up.
Why is procyclical behavior bad? Simple: it makes the swings of the economy more volatile. Hence during an upswing your holdings become even more valuable and this improves your bottom line, enabling you to acquire credit at lower and lower rates of interest; when the peak comes and the cycle starts back down, your assets become less and less valuable and your bank calls in your loans, rendering you ... bankrupt. Your operative business may be doing well, but as far as the accountant are concerned, that's irrelevant. Odd, that: normally, cash flow analysis is the most important thing to do when valuing a company. Apparently no longer.
Any sort of accounting rules that *encourages* this sort of ruinous cyclical valuation is in error at best and egregiously stupid at worst.
I see the problem as being based on the primacy of lawyers and accountants in the business world: while admirable in their own ways, neither really understands, fundamentally, the implications of what they are doing within the broader canvas of the economy. Hence lawyers arrange the laws to give them huge damage claims, but ignore the damage to the economy that such claims generate (think malpractice insurance costs to the health system); accountants have made their (negative) mark on the economy with this mark-to-market "philosophy" that tries to incorporate analytical work with descriptive work.
In both cases, these professions have benefited enormously, at a large cost to the overall economy, in trying to make their activities a fundamental part of doing business. Of course the accountants are fighting any sort of change in these rules: it's where they make lots of money and it's where they exercise power. Neither lawyers nor accountants want to give up either money or power: otherwise they have to revert to what they really are, simple service providers to the folks who actually create value, the businessmen and their employees who actually do the work.
Both lawyers and accountants do not actually create value in the economy: their fundamental role is to ensure that laws are followed and that at a given point in time, one can determine whether a company is making money or not. I think that their current role in the economy is parasitical and that they both - trial lawyers and big accounting companies in particular - have spent decades manipulating the legal and accounting systems to make their role larger and larger, until you have the situation today where their influence on how things operate is severely detrimental to the functioning of the economy, i.e. the parasite has become a cancer.
Only an accountant could believe that procyclical accounting rules could be a benefit. Any economist, heck any decent systems analyst, could tell them what is deeply, fundamentally wrong with the idea. The problem is that the accountants, especially the big accounting firms, don't want to admit that they are to a great degree responsible for this mess.
Re: I think that Leonard is right, in that suspending mark-to-market accounting is fairly insane.
However did the world survive, untethered to reality with "insane" accounting rules until 2002?
Not to dismiss the fact that the former regime had its problems, but returning to it will not be the End Of The World as we know it.
JonF: the catalyst for mark-to-market was Enron. That was the problem with the classic accounting rules: Enron was able to game the old system, and destroyed much that was good.
Unfortunately, we've gone from one appalling example of excessive greed ruining a functioning system to another appalling example of excessive greed ruining a functioning system.
Such is the pattern of development of human societies...
'foo'
What's the value of any asset? Whatever the market will bear. Mark-to-market is therefore tautological, as a concept. All accounting rules should mark to some market.
For a perishable asset, the only relevant market is today's market, so that's what you mark to. But for a durable asset, there are several markets -- today's, tomorrow's, the day after, for the durcation of the asset. For a perpetual asset, there is an infinite number of markets, from now to eternity.
The relevant market to mark to is the one when the asset will be sold. If you don't know that date, you have to mark to an estimate of a number of markets -- obviously, as any fool can see.
So, what's wrong with the current mark-to-market rule is that it evaluates very durable assets, housing, to one single market, i.e., today's. That guarantees a misestimation of the real underlying value of the asset in all future markets. If you have to make transactions by that rule, you will make errors that lead to wealth transfers from sellers to buyers.
What's the correct rule? Don't let SEC and the accountants and the politicians decide that. They will go wrong.
The common law principle is much better. As to Lyman's point that we need predictability in rules, that's a non-argument. Common law principles developed those rules for stable markets. The problem is always the unforeseen, and here the common law provides predictability in how rule making is done. That's much better than the turbulent winds of daily politicking that is essentially totally random.
What about instead using Mark-to-Holder-Ask? I'm no expert accountant, so maybe I'm missing something, but this seems to handle the worries on both sides, while still being honest and removing undesirable discretion from executives.
Mark-to-Holder-Ask means, as the name suggests, that they label the assets as being worth the lowest price that would convince them to part with the asset. That way, they don't have to mark it down just because of sudden crazy market downturns, and yet can be revealed as liars if someone makes a lower bid and they take it, which outsiders could do as a sort of sanity check.
Assuming that outsiders "call their bluffs" frequently enough, wouldn't that compel them to make a realistic valuation?
the common law provides predictability in how rule making is done.
What, by judges making it up as they go along (as the "common law" is practiced by courts today)? By seeking Biblical guidance (as they did during the historical development of the common law)?
I can't see how either is less random than Congress.
Accurate mark-to-market accounting provides all concerned - managers, investors, creditors and debtors - with the best available estimate of where an enterprise has got to today. This is still a weak estimate where there are assets for which no active market exists, and there is therefore no objective estimate of the price in a transaction between a willing buyer and a willing seller.
The logic of mark-to-market points to two changes in our current practice in accounting for these illiquid assets:
First, we need to introduce into our balance sheets a second valuation of these illiquid assets. This is the present value of the amount expected to be realised from an illiquid asset. This value will produce a positive (but illiquid) reserve where the present value exceeds the mark-to-market value; in which case it is a signal to hold the asset. If the reverse is true, a negative value is a signal to sell the asset. When there is a positive value in this reserve, the meaning to the market is that the break-up value of the enterprise exceeds its mark-to-market value (break up is not conducted at yesterday's prices).
Having got this far we have adjusted our accounting to the reality that no market is perfect, and it is often good business to hold an asset to realisation. A corollary is that there will be businesses that have zero or negative mark-to-market value but which which the accounts will show are likely to be profitable in future. In real, imperfect markets that will be no surprise.
At that point, the case for applying the logic of mark-to-market to the "m2m" valuations of illiquid assets becomes evident. They should be valued for m2m at fire-sale prices. The case against doing that now is that it would scare most people in business into irrational behaviour. However, if the illiquid assets reserve is introduced first, the possibility that some good businesses will show negative m2m bottom line value ceases to be a bogy. It will be part of the normal financial landscape.
All of which is no more than further steps in the never-ending task of improving our accounting so that it is a less imperfect representation of reality. Business - and economic growth - is founded on the quality of our accounting. If we revert to accounting which has been shown to be more imperfect than the present rules, the expected present value of our whole economy is reduced.
(Declaration of interest: I am an economist, not an accountant.)
Maybe.
Lets say I have a security issued legally in the country of Whatthefunkistan backed by a Whatthefunkistani slave labor company with a face value of $100 dollars that I fully expect will be paid at term, because I have faith that the company will remain profitable and make good its obligations under brutal Whatthefunkistani commerce law. However, I may have a very difficult time selling the security in the United States for $100-plus-minor-wiggle-room, because possessing such a thing is, if not outright illegal, at least very bad looking in the local environment. In other words, the local rules of the game distort the relationship between the current market value and the expected value.
Similarly, an institution might think that it can make a bundle buying up mortgage securities, but doesn't because they will look so bad on the balance sheet that they'll end up altering the institution's credit rating, unless the activity suddenly starts everyone else trading them at the new price and the market becomes liquid again. So, in a sense, it's not that the market prices are somehow wrong, but that the "intangible" costs dominate the list price.
Long before our life's savings became a political football, professionals knew that "mark to market" was a major force that could trip up our glorious new financial system forged by Bush-Clinton Republicrats. Rather than working to unwind the trouble spots in our unregulated markets, the ratings agencies, Congress and the lobbyists waited until McCain-Obama face off and America is about to vote to write the next chapter of American history.
Will this make it a face off (hockey), or a jump ball (basketball)? Who cares-- it doesn't matter, the next guy gets to play FDR as voters lose half their savings and pay much more tax, no matter who they pick.
Now, "mark to market" is the issue of the day? That was, more than few months ago. I'm thinking that the Columbia Journalism Review won't be giving out any honors to you guys for it.
Humpty Dumpty called, he said he's still on 33rd and 3rd, because he couldn't catch a cab to the ER.
What does this mark-to-market mess imply about the efficient market theory?
Steve,
I don't think it means anything. The market is efficient for people that are actually buying and selling something. The "Mark-to-Market" people are valuing an asset solely based on what other people are doing with it at the marking moment.
It looks like mark-to-market ignores what the owner feels the value of an asset is.
For example, if I had Peyton Manning in my fantasy football league, and marked him to market, he'd be a pretty poor asset right now (the Colts offensive line isn't doing very well.) But I feel like he's a better player than anything I could trade him for.
Dammit, since this whole thread started with a rant about Enron, isn't Mark-To-Market similar to what screwed over the California electricity market that Enron set up? You cannot rely on a spot market, it's too susceptible to wild fluctuations.
Hey smart guys, is there any particular reason we need to allow "illiquid assets" like mortgages to be packaged up into "securities"?
As far as "mark to market," it sounds like a good idea that has problems and needs tweaking. But that means new regulations, and regulation is a 4-letter word to a lot of people...some solution like Mario's moving average may be the most obvious solution to damping down the volatility. If that also damps down profits and therefore potential investment activity, isn't that a worthwhile price to pay in order to preserve the useful practice? Having speed limits of 70 MPH makes Lamborghinis kind of superfluous, yet people can still buy them...
Hey smart guys, is there any particular reason we need to allow "illiquid assets" like mortgages to be packaged up into "securities"?
It makes more money available to the mortgage market that might otherwise have gone to, say, corporate bonds. Also, the sale of mortgages generally (not necessarily securitization) allows originators like little local banks to manage risk and expand their offerings because they are not limited strictly by their deposits.
Still, it's obvious that our current method of doing it is less than optimal; probably it would be better to (say) set up a holding company to buy mortgages and have it issue bonds rather than playing the overly complicated repackaging games we've been playing.
That there are instances - very significant ones - where pricing is not efficient? So that the econ 101 that the right has used to 'scientifically' make the case for deregulation, increasing income inequality isn't really so 'scientific' after all? More synchronmicity from Economists View:
From the way things look now, it appears that a twenty-five-year-old slacker working the fry baskets Burger King added more value to the economy than titans of finance who were paid hundreds of millions or more who were supposed to do the same. People like Richard Fuld of Lehman Bros., Angelo Mozillo of Countrywide, etc. People who are also lobbying vigorously in Congress against inserting any clawback provisions if their performance was not up to snuff.
Oops, sorry about the link:
That there are instances - very significant ones - where pricing is not efficient? So that the econ 101 that the right has used to 'scientifically' make the case for deregulation, increasing income inequality, et. al. isn't really so 'scientific' after all? More synchronicity from Economists View:
From the way things look now, it appears that a twenty-five-year-old slacker working the fry baskets Burger King added more value to the economy than titans of finance who were paid hundreds of millions or more who were supposed to do the same. People like Richard Fuld of Lehman Bros., Angelo Mozillo of Countrywide, etc. People who are also lobbying vigorously in Congress against inserting any clawback provisions if their performance was not up to snuff.
Quick clarification:
Per FAS 157 (the current GAAP pronouncemnt for determining Fair Value), management is allowed to engage in pricing exceptions in instances where it believes that the current market price is not indicative of the full value of the asset. They will need to have backup to satisfy their auditors that they are not blowing smoke.
As for how often assets are revalued? That depends entirely on the entity doing the valuation. A manufacturer may revalue their plant and equipment annually, but their inventory much more frequently.
However, an open ended fund, such as a mutual fund, *has* to revalue their portfolio daily (known as 'striking a NAV' - NAV = Net Asset Value), in order to know the share price for those entering and exiting the fund. Private funds (hedges, private equity, etc.) that only allow money to flow in and out on a monthly or quarterly basis, can strike their NAV much less frequently and as a result have the luxury of using much more complex models than mutual funds.
Does Mispricing of Financial Assets lead to Mispricing of Human Capital?
Ya think?
Back when I was in college, something like 1/3 of my fellow graduates initially took jobs in consulting or I-banking. I wondered at the time why the hell anyone would want to pay me 6 figures for my deep insights into the business world. I also wondered what useful thing the were going to accomplish that would justify the pay.
I'm still wondering.
They made eight, nine or ten figures for their bosses. That's pretty useful, from the bosses' point of view...and that's the only one that matters, isn't it?
The market for anything determines what it's value is. I could say that my last empty beer bottle is worth a billion dollars because I said so, but that doesn't mean that I could actually sell it for that much......unless I had a bunch of slaves which were under my control and could be FORCED to pay for it. Guess what! That slave is the U.S. taxpayer!
When I file taxes for my trading activities, I must use the mark-to-market rules. My rules!? Nope. Someone else's.