Mark-to-Market Accounting

Posted on April 8, 2009 by Ben Connard 

Mark-to-market accounting has become a point of contention among banks, investors and politicians during the current financial crisis. Banks, with the help of politicians, blame the accounting rules for ruining otherwise healthy institutions. The argument is that banks are forced to write down assets to artificially low prices (because the market for the assets has ceased to function). These write-downs then reduce the bank’s equity and force them to conserve cash and restrict lending.On April 2nd, the FASB (accounting standards board) passed new accounting rules easing the mark-to-market requirements.

The rules require a company to write down the value of an asset if it becomes “other-than-temporarily-impaired” and recognize the loss on its income statement. In the past, banks could avoid an asset write down if the bank had the ability and intent to hold on to the asset until its value recovered. With the rule change, now the bank only has to intend to hold on to the asset and be more likely than not to do so.

In addition, the bank does not have to recognize losses related to the market conditions, only those related to the underlying creditworthiness.For example, if a bank has mortgage backed securities (MBS) worth $10 million in book value that have a current market value of $6 million they don’t have to recognize the entire $4 million loss. They could state that $3 million of the loss is due to market illiquidity and only $1 million due homeowners’ not paying their mortgages.As a result, they only write down $1 million and their equity is reduced by $1 million.

Basically, the new rules give banks more freedom in determining whether or not they will write down an asset.The arguments in favor of the rule change are focused on the illiquidity of the current market for MBS. Banks are arguing that based on the underlying homeowners’ creditworthiness, these assets are worth near book value because most homeowners are still paying their mortgage.In other words, their cash flow valuation is near par. The only reason the market is giving such a discount is that everyone is afraid to buy these assets due to panic/fear.Of course, the fear is that the homeowners are not going to pay.

Banks are happy with the new rules because they now have more discretion in determining the value of their balance sheet. Banks have an incentive to put an inflated value on their assets which increases their lending ability and maybe even their stock prices. Some investors are not as happy because bank balance sheets are less objective. The investor just wants an accurate valuation.If a bank shows $100 million on its balance sheet, an investor should feel confident the bank could dispose of those assets for $100 million. Asset valuation is very important since the banks themselves borrow so much money.Unfortunately, the banks themselves do not have the ability to also reduce what they owe to their creditors.

One supporter of the rule compared it to an individual’s portfolio getting hit with a paper loss.He stated that if you buy a stock worth $10,000 and expect it to climb to $25,000, if it falls to $6,000 you don’t write off $4,000. You hold the stock and hope it climbs to your predicted $25,000.While this may be true, if you went to borrow money against the stock, no bank is going to assume it’s worth $25,000, or even $10,000. They’ll use $6,000.

Banks, on the other hand, are asking us to assume it’s worth $25,000 and value their stocks accordingly.