Tuesday, July 7, 2009

Mark to Market Accounting - Did it Cause the Meltdown

I was involved in an interesting discussion last week on "mark to market" accounting. For those not up on the subject (at least 99% of the population falls in that category!), the mark to market rules required banks and other entities to adjust the carrying value of various assets to current market values. That is what they mean by mark to market - as in marking it down.

Most GAAP financial reporting is done on a historical cost basis. There has been an ongoing trend to more fair value reporting, especially as the US account principles start to converge with international standards. One area that has been switched to market value was investments in marketable securities - stocks, bonds, mutual funds, etc. Depending on how you classify these assets impacts how the gain or loss on them is recognized - unrealized gains and losses on securities held for trading purposes directly hit the income statement, while those on available for sale securities go through comprehensive income, a component of the equity section of the balance sheet.

The mark to market rules have gotten a lot of criticism and taken heat as being a cause of the financial market meltdown. Why? Because subprime loans and other financial assets had to be marked down to current value. And that made the companies holding these assets look bad! The argument was that if these rules were done away with then the companies would look better and none of this would have happened.

A large number of members of Congress have written the Securities and Exchange Commission asking that these rules be rescinded for public companies. That alone should tell you the rules are not the problem.

The truth here is that these companies were holding a lot of bad assets. The mark to market rules made this clear. Not having the rules in place would have hidden this information, but either way the companies were holding bad assets.

Did the mark to market rules create the financial meltdown? No. That was going to happen. Did it help accelerate it? Maybe, but that is ok.

Any contrary thoughts?


Prometheus said...

Mark to market accounting does not take into consideration a market that has dwindled or temporarily halted - as happened with the credit crisis. I don't think accounting rules caused the cash crisis, but the SEC and government enforcement of a rule that should never have applied to real estate did make it worse.

Real estate has real value; it is a physical asset. It can never have a value of $0! Selling prices may fluctuate, but the market is never, ever, dead.

The bottom line is that an asset is worth what the buyer and seller agree to during the process of selling and buying the asset. It is not an arbitrary number picked by "those who know" what the "market value" of a real estate asset is. Market value is what you get *after* something sold has been bought. One neighborhood may have houses that sell in a general range, but the range doesn't dictate any specific transaction's final value.

In the end analysis, the government's agencies enforcement of mark-to-market accounting, resulting in a wholly arbitrary determination of real estate value, is patently absurd. It comes down to what the government THINKS the "market value" of a specific, or market for, real estate.

This exacerbated the credit crisis at the exact time the market could not afford to have real estate values arbitrarily devalued simply because there was no current market for most real estate. Again, the market value can fluctuate, but it can NEvER equal zero.

If you want to look at the real culprit, examine the lending policies of FNMA and FMAC, as pushed by the Clinton and Bush administrations. They backed loans to people that any sane bank would refuse - because people "have a right to affordable housing." Yeah, and I have a right to a Mercedes-Benz. Sports car; red color preferred, with leather seats please.

Government insanity created and exacerbated the credit crisis. And that's the truth.

Joel Ungar said...

Prometheus - you have some good points and thanks for sharing.

Government agencies should stay out of rule setting. I'm heartened that Barney Frank says as long as he's running his committee (can't remember which one it is) the government won't legislate GAAP.

Oh, and being from Detroit, I think I'll settle for one of the hot new Mustangs, 5 speed on the floor, convertible.

James Beck said...

You're very diplomatic, though Prometheus' argument is an obvious straw man. There's a huge difference between requiring firms holding derivatives on a first-to-fail vehicle to market and ordering them to mark the underlying assets to $0.