Mark To Market

Some headlines from Bloomberg today:

Manufacturing in U.S. Contracts at Faster Pace Than Economists Estimated
Cash-Starved Corporations Scrap Dividends, Tap Credit Lines to Raise Funds
Trichet Says Congress Must Back Bailout Plan for 'Sake of Global Finance"
Treasuries Rise; U.S. Growth May Slow Regardless of Rescue Plan
Bank Bond Spreads in Europe at Record on Funding Woes

Aside from a relief rally in stocks yesterday, you can see from the headlines things have not improved much in the credit market trenches. Of note was a "clarification" by the SEC and Financial Accounting Standards Board or FASB regarding a rule called "mark-to-market". This long standing principle forced financial companies to review assets on their balance sheet for more current values and adjust them accordingly. Banks used to be able to record assets at "book value" and adjust them only occasionally or upon disposition. As you might have surmised already, mark-to-market generally relies upon the last trade or market value of a security to value it.

What does this mean? Imagine you are a bank and buy $100 million of mortgages. If you do not have to adjust these precisely for the last trade, the value is going to fluctuate very little depending on the assumptions. If losses are modest, the $100 million may get adjusted slighty or not at all if the losses are within expectations or assumptions. Now imagine the securities trade on a market, like so many securitized financial assets these days. Investors are selling these assets out of fear and pushing the price down far lower than anyone expected, say to $0.70 on the dollar. Under mark-to-market accounting, the bank MUST take a $30 million loss and lower the value on it's books.

So? In normal times, mark-to-market keeps everyone honest. No management can rig their books by simply making rosy assumptions (Enron employed this tactic in spades) about an asset's value because the last trade on an independent market determines the value. This provides transparency for investors who provide capital to financial institutions. Banks used to complain that mark-to-market (MTM) introduced unnecessary volatility, but it really only caused problems once the panic set in.

As panic set in and securities began plummeting in value, it forced institutions to write down assets much faster than ever. In past downturns, banks could take time to write down loans (years instead of months) and "earn" their way through it. They could use current profits to offset writeoffs. What used to take years is now happening in months, impairing capital faster than it can be replaced.

The "clarification" issued yesterday encouraged companies to rely more on thier own judgments in arriving at the current value of assets which aren't trading or are very illiquid. Whether MTM is good or bad is a bit controvercial. Some advocate that an accurate, independent, up to date picture of a company's books is critical to transparency, trust and fairness. Some argue it creates too much volatility. Both have legitimate arguments (personally, I favor MTM for most securities), especially since "fair value" accounting (the opposite of MTM) consisently results in abuses (e.g. Enron). Will suspending MTM rules help the current situation by slowing writeoffs, or will it hurt by institutionalizing the complete lack of trust hurting markets right now? It's a tough call. I tend to think MTM is important for transparency, but the Paulson Plan can remedy the paradox by buying assets and setting a real, fair price for them in the market, helping institutions shore up their balance sheets.  (As discussed yesterday).  At least regulators other than Congress are looking for ways to stem the panic- which is a good thing.