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The Failures of Mark-to-Market Accounting


It still falls short of its goal while instigating confusion over bank and investor positions.

As the credit crisis commenced in 2007, paradoxically, nobody actually defaulted. Outside of sub-prime delinquencies, corporate defaults were at a record low. Instead, investors in high-quality (AAA- or AA-rated) securities, those of which are unlikely to suffer real losses if held to maturity, faced paper -- mark-to-market (MtM) -- losses.

In modern financial markets, market values drive asset values, profits and losses, risk calculations, and the value of collateral supporting loans. Accounting standards, both in the US and internationally, are now based on theoretically sound market values that are problematic in practice. The standards emerged from the past financial crisis where the use of "historic cost" accounting meant that losses on loans remained undisclosed because they continued to be carried at face value. The standards also reflect the fact that many modern financial instruments (such as derivatives) can only be accounted for in a MtM framework.

MtM accounting itself is flawed. There are difficulties in establishing real values of many instruments. It creates volatility in earnings, attributable to inefficiencies in markets rather than real changes in financial position.

Alan Greenspan once noted: "It has been my experience that competency in mathematics, both in numerical manipulations and in understanding its conceptual foundations, enhances a person's ability to handle the more ambiguous and qualitative relationships that dominate our day-to-day financial decision-making."

He may be the only one qualified to understand modern financial statements.

MtM accounting falls well short of its objective: the provision of accurate, reasonably objective, and meaningful information about financial positions. In the present crisis, it's heightened uncertainty and confusion about the position of banks and investors.

Mark-to-Market and Its Discontents

MtM accounting requires financial instruments to be valued at current market prices. This assumes a market and a price. As Michael Milken, the progenitor of "junk bonds" at Drexel Burnham Lambert, once noted: "Liquidity is an illusion. It is always there when you don't need it and rarely there when you do."

In volatile times, liquidity becomes concentrated in government bonds, large well-known stocks, and listed derivatives. For anything that's not liquid, MtM means mark-to-model. This assumes universally accepted pricing methodologies with verifiable inputs. Valuation for all but the simplest instruments today requires a higher degree in a quantitative discipline, a super computer, and a vivid imagination. For complex structured securities and exotic derivatives, the only available price is from the bank that originally sold the security to the investor. Prices available from the purveyor of the instrument (a concept known as mark-to-myself) strain reasonable concepts of independence and objectivity.

A current market price of 85% for a AAA security doesn't actually mean you'll lose 15% of the face value. It's only an estimate of likely losses. It may reflect the opportunity loss of being able to invest in the same or similar security at the time of valuation. In volatile markets, excessive uncertainty or risk aversion means that values deviate significantly from actually cash values.

MtM prices may be prone to manipulation. An often-neglected element of the Enron scandal was the company's ability to convince its auditors and the US Securities and Exchange Commission (SEC) to allow MtM accounting to be used in the natural-gas industry, allowing the company to record current earnings based on the future value of long-term contracts.
No positions in stocks mentioned.

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