Wednesday, October 1, 2008 at 6:25 pm
Suspending mark-to-market is for zombies
The politicians in Washington, especially the Republicans in Washington, are all fired up at the moment about the scourge that is mark-to-market accounting. The bailout legislation approved by the Senate Wednesday night to be considered by the Senate tonight merely tells the SEC chairman that he has the authority to suspend mark-to-market, and commissions a study on the matter. But prominent Republicans such as Newt Gingrich and Grover Norquist have been calling on the Bush Administration to strongarm SEC Chairman Chris Cox into rescinding mark-to-market now.
For readers who haven't been following all this, a quick recap: Mark-to-market accounting means valuing the financial instruments on a bank's (or any company's) balance sheet at what they would fetch on the open market today, as opposed to at their historical cost, which is the way things used to be done. It's also often called fair-value accounting, and it's been the law of the land--or, more accurately, the GAAP of the land--since the early 1990s, although Statement of Financial Accounting Standards No. 157, which went into effect last year, tightened up the rules a bit.
The big complaint at the moment is that markets for some mortgage-related securities have so totally broken down that marking them to market dramatically understates their value and makes banks' finances look much shakier than they really are. The SEC and the Financial Accounting Standards Board put out a joint statement Tuesday clarifying that if the market for a particular kind of financial instrument really was dysfunctional, it would be okay to not to rely totally on current broker quotes or recent distressed sales of such instruments in determining their value. This wasn't so much a change in policy as an attempt to point out that mark-to-market rules do allow for some amount of flexibility. "It's mostly common sense," Credit Suisse accounting analyst David Zion said in a report to clients Tuesday.
But what the most outspoken critics of mark-to-market seem to be calling for is a much bigger change--a move away from the direction accounting has been headed in for almost half a century. Mark-to-market had its roots in the efficient-market revolution in finance in the 1960s--whose adherents believed that the prices prevailing in the stock market and other financial markets were near-perfect reflections of economic reality. Such thinking soon prevailed in academic accounting circles as well, and the accounting professors began pushing for accounting standards that fit with their new worldview.
The savings and loan mess of the 1980s, which became such a big mess in large part because S&Ls didn't mark their assets and liabilities to market, provided real-world impetus for such a shift. Most S&Ls became insolvent in the early 1980s because of the mismatch between the double-digit interest rates they had to pay to borrow money and the 5% to 6% a year they were earning on the 30-year-fixed mortgages that made up the bulk of their assets. But the accounting standards of the day obscured this grim reality. Some S&Ls--like Washington Mutual--took advantage of the reprieve to trim down, shape up and get themselves out of trouble. Many others became what's known as zombie banks, lurching across the landscape running up ever bigger losses until taxpayers had to put up several hundred billion dollars to shut them down and pay off insured depositors.
So in December 1991, the FASB decreed (pdf!) that there should be fair-value accounting for financial instruments. And lo there was fair value accounting for financial instruments! While there have been lots of debates through the years over the particulars of how to implement it, the basic idea had in recent years ceased to be very controversial. The lack of fair-value accounting in Japan and the resulting scourge of zombie companies were often cited, in fact, as key causes of the country's economic stagnation in the 1990s. (By the way, Japanese accounting authorities finally began moving toward mark-to-market last year.)
Earlier this year, though, complaints that mark-to-market was worsening the financial crisis began to surface. Blackstone's Steve Schwarzman was among the most prominent critics. And while much of this talk was self-interested hooey (why wasn't Schwarzman complaining about mark-to-market in 2006?), there was also an important intellectual shift at work.
The efficient market hypothesis, which had helped launch fair-value accounting, was no more--at least not in the sense it was understood and believed in the 1960s through 1990s. (Self-promotion alert! You can read all about this in my book The Myth of the Rational Market! Coming out next spring/summer! Really!) Hardly anybody believes any more that market prices are necessarily right in any fundamental sense. But most finance and accounting scholars do still believe that it's really hard to determine a price that's more right than the market price.
So where does that leave mark-to-market accounting? On Tuesday I let my friend Paul B.W. Miller, a prominent mark-to-market advocate, go to town on this subject. A sample:
[R]eports that are truthful are more useful than those that are not; reports based on assumptions and predictions are not as reliable as reports based on observations; mark-to-market reports are based on observations; other methods of accounting are based on assumptions or untimely measures of investments (e.g., cost); ergo, MTM accounting is superior to other forms.
But today I was talking to Gene Flood, a former Stanford finance professor who now runs the fixed-income money manager Smith Breeden Associates, and he surprised me by saying that he is no longer quite the fervent believer in mark-to-market that he once was. "The credit crisis has caused such a liquidity crunch that market prices are not a good reflection of true economic value," he said. "If you are forced to mark everything to market, then you are not getting a good economic picture of the economic health of the institution."
Flood doesn't want to suspend mark-to-market accounting. He just agrees with the new FASB/SEC directions for companies to pay less heed to prices coming out of clearly distressed markets. Paul Miller doesn't have a big problem with this guidance either.
Which leads me to the following conclusions.
First, as commenter That Anonymous Dude puts it, "MTM is the worst form of accounting, except for all those other forms that have been tried from time to time."
Second, investors and regulators and reporters and corporate executives need to learn not to take any financial reporting numbers, whether marked-to-market or not, at face value. The health of a bank or any corporation can never be adequately measured by a single bottom-line number. Understanding the assumptions and uncertainties inherent in accounting numbers is crucial to understanding how to use them.
Third, Congress really ought to stay out of this. The last time the people on Capitol Hill seriously messed with accounting standards was with stock options in 1994. In the process they ruined America. As some guy wrote in Fortune a few years ago:
[W]hat it came down to in 1994 was that the powers that be in American economic life decided that dishonesty in the service of prosperity was no vice. In doing so, they may have paved the path for the outrages that followed. "Once CEOs demonstrated their political power to, in effect, roll the FASB and the SEC, they may have felt empowered to do a lot of other things too," says Warren Buffett, a lonely voice in opposition to the options steamroller back then.
Fourth, if Republican opinion-makers like Gingrich and Norquist really do believe that financial market prices are so horribly wrong, maybe they need to do some reexamining of their core economic beliefs.
18 Comments to “Suspending mark-to-market is for zombies”
Leave a Reply
You must be logged in to post a comment.
About Curious Capitalist
RSS Feed
 |
Daily Email
Recent Posts
The Curious Capitalist - TIME.com Archives
Blogroll
- Adam Lashinsky
- Amit Varma
- Barry Ritholtz
- Brad DeLong
- Calculated Risk
- Econbrowser
- Econlog
- Ezra Klein
- Felix Salmon
- Floyd Norris
- Going Private
- Greg Mankiw
- Herb Greenberg
- James Pethokoukis
- John Gapper
- Marginal Revolution
- Mark Thoma
- Matt McAlister
- Megan McArdle
- Michael Mandel
- Mike Moffatt
- Nicholas Carr
- Paul Kedrosky
- Roger Parloff
More TIME Blogs
Top Stories
- Why Obama Wants Hillary for His 'Team of Rivals'
- Is Mark Cuban Guilty of Insider Trading?
- In Zimbabwe, Mugabe Clings On, But His Power Is Waning
- BlackBerry Storm: The Novelty Wears Off Fast
- John Boehner Talks About the GOP's Plight in Congress
- As Somali Pirates Get Bolder, Policing Them Gets Tougher
- Stressed Out Hong Kong: Now, More Stressed Out
- Ford Might Be the Winner if the Auto Bailout Fails
- Why the Democrats - and Obama - Forgave Lieberman
- 'Saved by Zero': The Toyota Ad That Won't Stop
Top Photoessays and Slideshows
- Photos: The Brazen Pirates of Somalia
- The Politics of Water in Central Asia
- Pictures of the Week
- Mass Suicide at Jonestown: 30 Years Later
- Fade to Black
- Bao Xishun, the World's Tallest Man
- Planet Earth: An Illustrated History
- Prince Charles Turns 60
- Barack Obama: The Best TIME Photographs
- Somalia's Face of Modern Piracy
Wednesday, October 1, 2008 at 9:03 pm
I am a Republican (yes, still), but Grover Norquist has become my placeholder for the most imbecilic, anti-intellectual, fringe thought in the party. Tell me Grover is for something, and that is almost the bellwether for it being a stupendously bad idea.
Let me know if I am wrong in this.
Wednesday, October 1, 2008 at 9:50 pm
i use glenn beck for my own contra-indicator
Wednesday, October 1, 2008 at 9:59 pm
"But today I was talking to Gene Flood, a former Stanford finance professor who now runs the fixed-income money manager Smith Breeden Associates, and he surprised me by saying that he is no longer quite the fervent believer in mark-to-market that he once was. "The credit crisis has caused such a liquidity crunch that market prices are not a good reflection of true economic value," he said. "If you are forced to mark everything to market, then you are not getting a good economic picture of the economic health of the institution."
This isn't contradicttory either...by deciding the market is mispriced you can buy/sell and hope t make a buck. What you can't do is claim to be right until the market says u are (and u can buy/sell for correct price)
Wednesday, October 1, 2008 at 10:22 pm
"Fourth, if Republican opinion-makers like Gingrich and Norquist really do believe that financial market prices are so horribly wrong ..."
That's a huge unwarranted assumption about consistency, integrity and such matters.
Wednesday, October 1, 2008 at 11:18 pm
MTM no longer means marked to market or marked to model.
It means market to morons.
Thursday, October 2, 2008 at 11:03 am
this "financial crisis" is indeed the "crisis of the capitalist ideology," ripe with conflicts of interests, full of empty words and numbers backed by no substance.
You're watching the implosion of the house of cards, as Marx predicted hundreds years ago.
Thursday, October 2, 2008 at 11:48 am
MTM is an essential accounting convention that should be preserved in its present form. It may be inaccurate at any point in time but it's self correcting and helps to prevent economic fantasies - intentional or otherwise.
Thursday, October 2, 2008 at 11:55 am
What Bob said.
Thursday, October 2, 2008 at 11:59 am
If banks have to use MTM in judging its assets, why is the government not using MTM as the "price" for what it is willing to pay for distressed assets? If MTM is so good, then why does the government keep telling us "we are going to pay more than MTM because 'everyone know these assets are worth more than the MTM price."
Can't have it both ways....
Thursday, October 2, 2008 at 12:20 pm
I need to take a moment from closing the books to address this...
I think the author is missing the point. Classic accounting (pre 1990's) required a lower of cost or market. This conservative approach required companies to record assets on the books equal to the amounts paid for them. If the value of the asset decreased due to market conditions, the value would be written down, decreasing a companies earnings. Increasing the value of an asset due to changes in the market was not allowed, and therefore no enhancements of earnings occured. This resulted in financials that were a base line of value of a company.
In my opinion, the MTM problems occur with the writing up of the assets. This allowed an increase to earnings, based upon current market conditions. In theory is ok, if an established market exists. However, with these exotic financing instruments, you can't look up the value on an exchange, since a traditional market does not exist. As a result, the company calculates the market value on its own. This is where the problem occurs. Trying to value an asset to market where one does not exist is flawed - the answer will always be wrong.
And which way do you think the error will go?
This is why executives get large bonuses in the current period on underlying 30 year financial instruments (aka mortgages). This is not that different from the Enron debacle.
Bring back lower of cost or market. Simple and safe.
Thursday, October 2, 2008 at 1:24 pm
"Third, Congress really ought to stay out of this. The last time the people on Capitol Hill seriously messed with accounting standards [blah, blah, blah]"
But it is okay for the SEC to decree the use of certain accounting standards? Are you not aware that the SEC enforced the MTM rule because it initially thought it was legally required to under Sarbanes-Oxley, a law passed by Congress?
If you really believed your statement, then why are you not outraged about "the last time the people on Capitol Hill seriously messed with accounting standards"--the Sarbanes-Oxley Act, which is all about meddling into accounting issues?
Or do you only believe your own statement when it preserves other forms of government interference into the free market?
Hypocrisy much?
Thursday, October 2, 2008 at 1:29 pm
Historic cost is not entirely without significant issues as well tho...
These are all simplistic examples..
Issue 1 - Inability to compare time differentiated assets and liabilities
----------------------------------
Acme Corp buys is corporate building for cash in 1980 for $100k. In 2009 it has a fantastic idea and takes a secured loan against the building for $3mil to fund the idea.
Assets: $100k
Liabilities: $3million
Do we know if the building is worth $3mil? No. We do know it is almost certainly worth more than $100k tho.
Imagine thousands of these piled up in a real companies books.
Issue 2 - Inability to compare similar companies due to time differentiated asset recording
---------------------------
CopyCat Corp likes acmes HQ so much, in 1995 it buys the identical building across the street for $1.5mil. It also has the same idea and takes out the same loan..
Acme:
Assets: $100k, Liabilities: $3mil
CopyCat:
Assets: $1.5mil, Liabilities: $3mil
While neither of these companies looks like a great balance sheet, acme looks like a stinker comaratively, even tho it is in fact exactly the same.
And again, the idea is to remember there will be hundres, thousands, millions of these assets and liabilities on the books across any company of any medium to large size. Many of the details won't be broken down to any useful detail in the books for investors to look at..
This is not to say that the issue of bonuses rewarding short term behaviours of CEOs and traders. It is a valid point. But conservative historic cost accounting seems to create some problems as well. In fact, it may create the incenvtive to do deals just for doing them to realize some gains (and not have to worry about unrealized losses).
Thursday, October 2, 2008 at 1:42 pm
@Wendy: Of course it's okay for the SEC to decree the use of certain accounting standards. Congress delegated the job to it in the 1930s, although the SEC in turn usually delegates the nitty gritty work to FASB. Congress has the right to revoke that authority at any time, of course, but I would think we should all--whatever our opinions on mark-to-market-- dread the thought of Congress actually writing our accounting standards.
As I noted in my post, mark-to-market accounting has been the standard since 1991. I fail to see how Sarbanes-Oxley (passed in 2002) has anything to do with it, other than by holding top executives more accountable for any false accounting statements. But I do see that connection made a lot these days, so I'll do some checking on it.
Thursday, October 2, 2008 at 1:59 pm
I think the above example is missing a piece...
When you take out a $3.0M loan securitized by a building on the books for $100K or $1.5M you still receive a Cash! Presumably, the use of that cash is going to create revenue or to purchase a seperate asset that will increase the overall value. The above example assumes the cash has come in and was squandered...
Lower of cost of market does have problems - it leaves casual investors with out an good understanding of the upside of company assets. But we can hardly argue that they have been better served by mark to market...
How about keeping the books at lower of cost or market, and disclosing the Market values in the footnotes?
Thursday, October 2, 2008 at 2:15 pm
you raise a fair point regarding the cash, but it the central point is the difficulty of making comparisans between companies where the value of assets is differentiated by its timestamp even when the same remains.
"it leaves casual investors with out an good understanding of the upside of company assets"
but i think this raises an important point, not intended. The reality is NO accounting system will save a CASUAL investor from themselves. too many people (pros and amateurs alike) apply non-rigorous/non-existent analytical processes to problems such as investing - and you can't save them from themselves no matter what you do really.
Thursday, October 2, 2008 at 3:30 pm
Agreed! No system will save a casual investor... or work to their Benefit!
Caveat emptor... but it is hard when it we create millions of casual investors through 401(k) plans, and deal with political leaders who alternate between blaming the market for all ills and praising it for all benefits...
Is it truly a roulette wheel?
Thursday, October 2, 2008 at 4:34 pm
Rob,
It appears that lower cost of market is a more conservative method of valuing assets at the outset for which their is no market or they are highly illiquid.
Is there any other method? I think the reason many people are starting to sound the horn on mark-to-market is because they are ignorant (at least, I will admit as much).
Let's take the following scenario recently explained to me:
Imagine a street where the houses are all worth $1 million, and each has a $500,000 mortgage. But a clause specifies that if a house's value declines to less than double the loan, the mortgage will go into default. Now, suppose one homeowner is forced to sell, and has to accept a lowball offer of $600,000. Using mark-to-market rules, the lender would have to judge all the other homeowners technically in default, forcing them to raise additional cash or perhaps sell their homes. That's what has been happening in the financial world.
What is the appropriate way to deal with this situation? Thanks for your earlier posts. Most helpful.
Thursday, October 2, 2008 at 8:40 pm
Great question Bryan
I'm pretty sure the old accounting rules allowed for judgement in determining temporary vs permanant decreases in value.
I don't think that accounting pronouncements and rules would make any difference on the above example. The loan contract is the problem, allowing for the loan to be called based on certain contingencies.
The solution is to not enter into a contract with the underlying contingency. I don't think standard mortgages have this (it is a different issue if you stop making payments, but I bet highly leveraged financial instruments do!