Mark-to-Market vs. Mark-to-History

by: Bo Peng October 05, 2008    

Bo Peng

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By now it should be no question that the Fair Value Accounting rule has driven some firms into a death spiral, and been an important amplifier in the financial nuclear chain reaction we've been witnessing.

To illustrate the point, as if it needs more illustration, let's consider a sudden cut-off of gasoline supply. The cause of the cut-off is such that we can be reasonably sure of its revival, but can't be sure when. The Lambo you just bought last year is worth little on the spot market.

"That's fine," you say to yourself, "I'll just park it for now."

Unfortunately, it's not fine. You used it as part of the collateral on your new Starbucks shop. WaMu texts you at 4pm asking for more collateral. "Or else c u in court," it says, "Sorry, must do MTM." But you happen to be tight on cash. You look around the house and come to the conclusion that the only option is to give up. You let your 10 Starbucks employees go. The next month five of them go delinquent on their mortgages. And these happen to be the last straw that pushes WaMu under the 6% capital ratio stop.

WaMu's insistance on Fair Value Accounting ultimately caused its own demise in this fictional scenario. It's stupid. It's unfair to everybody involved. It's self-inflicted damage, mutually-ensured destruction.

However, supporters of Fair Value Accounting also have a point. Imagine the same scenario above, with one of the following variations:

  1. The cause of the gasoline cut-off is such that we can't be sure it could ever revive.
  2. WaMu thinks that you will default soon regardless because it knows your Starbucks is in trouble. It'd have to sell the Lambo on the market afterwards since it doesn't intend to park it at its own expense and take the risk on it.

It's simply not the regulators' job to judge the market outlook or intention of the company. And, if the company management, when given the option of suspending mark-to-market accounting, comes out saying "we don't intend to sell these mortgages anyway", how can anybody trust them? This is not even a swipe at honesty of corporate manangement. Unexpected events may force companies to change strategy with little warning.

But the solution is so simple it's puzzling why it hasn't been discussed widely and considered sincerely. Just ask companies to report both mark-to-market and mark-to-X on financial assets. The market will have to decide how much of which to use to evaluate the company, and price its stock, bonds, CDS, etc accordingly.

Take Lehman as an example. Its rapid collapse caught most people by surprise, at least before 9/11, the Thursday before its demise. While some hedge funds had been shorting Lehman for months, I'm not sure even they believed Lehman would go down so quickly, especially after the Fed window opened up after the Bear Stearns bailout. If Lehman had the option of dual reporting, people would've valued it somewhere between the two numbers, perhaps even closer to the mark-to-X number.

Trust and confidence can be a self-fulfilling prophecy. If people hadn't been afraid of Lehman's capital solvency, to a large degree due to artificial, nominal paper losses imposed by Fair Value Accounting, they would have continued doing business with it, albeit with somewhat heightened prudence. And Lehman could've survived -- if it had survived till the credit market stabilizes, it would've survived, looking pretty sitting on massive gains as most of the previous Fair Value Accouting write-downs are eventually recouped. The AIG (AIG) bailout may not have been necessary as a result. And tax-payers could've saved a cool $700B (probably more).

The X in mark-to-X could be the moving average market price of the asset, or assets of similar nature, over the last, say, one year after forward discounting. Many details must be carefully considered, of course. But I'll not dwell in them here.

This dual reporting approach has an interesting self-correcting effect if capital requirement is based on mark-to-history. In a bull market, the effectively higher capital requirement, due to time lag and lower-than-market price basis, limits the risk growth while in a bear market, effectively lower capital requirement offers relief and time to adjust. The latter is especially critical in a disaster scenario.

This dampening effect contrasts with the destabilizing effect of positive feedback of mark-to-market: companies are allowed to take on more risk based on paper gains in a bull market, reaching the height of risk just as correction is due, and forced to delever in a bear market, just when they can least afford to do so.

Even the most fervent defenders of mark-to-market admit its destabilizing effect under severely adverse market conditions. Mark-to-history capital requirement coupled with dual reporting can substantially eliminate the negative effects while retaining the positive ones.

Disclosure: None.

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This article has 30 comments:

  •  
    Oct 05 08:02 AM
    Dead on. This seemingly 'rational' accounting rule, has wrecked havoc in the current market, where there is no comparable value for the sale of a mortgage portfolio. Suspending, or alter it for the financial stocks would make all the sense in the world, and had it been done a year ago we would not be where we are now.

    Imagine a world where Bear, Lehman, and AIG had NOT required intervention. We might not be entering a recession, and the current 'bailout' might well not even have been discussed. Because suspending it would have 'looked bad' it was not done, and now we are much worse off. The regulators failed us, but not by under regulation, but by not regulating sensibly.
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  •  
    Oct 05 08:18 AM
    Go Figure...it has all become a free for all irratioal market place...& i guess just about anything goes...to & for & by, the ever changing "casino like" house always win$, like rules...i agree with the Dick Grasso & Ken Langone, best ever interview with, Neil Cavuto on Fox Business News,
    Reply | Link to Comment
  •  
    Oct 05 08:42 AM
    Yep! And lets eliminate margin calls based on the market prices of securties. Cost is definetly much more realistic.
    Reply | Link to Comment
  •  
    Oct 05 08:59 AM
    a useful suggestion meriting further examination.
    > jack
    Reply | Link to Comment
  •  
    Oct 05 09:28 AM
    This makes too much sense and so it would be impossible for the people in Washington to use it. All they can talk about is more money, more for their political buddies, more for lobbyist in the end. This package has already been widely discussed and no one knows if it will work yet a simple proposal such as the one above could have been tried before committing the country to 8B dollars of more debt and giving the very people who have caused so much of the problem discretionary spending of it. We should vote the whole group out in Washington and start over. We couldn't do any worse. It's time for term limits in Washington, and I know we have to vote on them, but people tend to vote for the names they know plus most of the sitting politicians have such huge war chests it's hard to compete with them when campaigning.
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  •  
    Oct 05 09:51 AM
    Great article - Concise and logical. Mark to Market works fine in stable markets, but in a falling market it creates lots of failure. There is an analogy to Margin Calls.

    This is similar to a companies inventory, where the requirement is value the inventory at the lower of original price or current market.

    There is a double standard. In a real estate mortgage, the bank does not call you until you can't make your payment.
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  •  
    Oct 05 09:58 AM
    Agree with MArk to MArket as the root cause for this debacle. Mark to Market is an atrociity foisted upon us by the DIMLIBS in Washington via Sarbanes/ Oaxley.

    Time to dump Sarbanes/Oaxley once and forever.

    However I disagree with your solution of setting up a new indexed artifical standard.

    IMO the best solution is the proven solution = go back to the future and reinstate the time tested and proven balance sheet rules for valuing assets.

    cost OR Market as determined by the company with "write downs" and "write offs". Allowed by rule at management discression with accompnaying footnoted justification. AND required upon disposition of the specific asset.

    What's wrong with what works? the value of underlying capital assets is the "ballast" in the balance sheet, which -just as the ballast in te bottom of a sailboat - allows the boat to float and keeps the boat stable and keeps the boat from capsizing.

    Thanks for nothing to all politicians who caused this problem thru their stupid attempts to force FANNIE MAE and FREDDIE MAC and all banks to make bad mortgage loans to minorities and others in the name of "social engineering" And specially to the DIMLIB democrats who over the years led this effort = Bubba bill. clinton, Barney Frank,Al schumer, Paul Sarbanes, Oaxley, Chris Dodd, Joe Biden, and of course Barak Hussein Obama.

    A pox on both your houses.

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  •  
    Oct 05 10:19 AM
    Excellent point. It is a complex world and rules are meant to keep an even keel--not capsize the boat to port rather than starboard! Unfortunately, we've only seen the first squal--when the Alt-Option loans start defaulting en-masse, we will need a multi-trillion dollar backstop. Maybe the central bank of Mars will inject some liquidity. One thing for sure, a lot of baby boomers are going to work-to-tombers...
    Reply | Link to Comment
  •  
    Oct 05 10:26 AM
    Apparently the banks made a bunch of bad loans, i.e. loans where people do not pay monthly as agreed. We can look at reality (there are $40 trillion of home mortgages) and realize that our leading bankers went bankrupt, or we can pretend it didn't happen and try to blow the next bubble. In a fiat money based system it is just a question of when too big to fail won't cut it any longer. Not that the Chinese, Russians and many other bankers who have been meeting in private without the USA aren't working to bring us down. Reserve currency status is worth at least 5 trillion a year; if we get the 5 trillion someone else doesn't...
    Reply | Link to Comment
  •  
    Oct 05 10:59 AM
    petyaczar, you also hit the nail on the head when you said that the problems were caused by politicians who passed the CRA bill and forced the banks to make loans to people who could not afford them and would not have qualified otherwise. This did not help the homeowners in the long run nor the banks. Another case of government intervention screwing up the free market place.
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  •  
    Oct 05 11:22 AM
    Good idea in principal... but I'm not sure public companies are allowed to issue multiple choice financial statements. That might cause too much ambiguity for investors. For example, which number would be reported for tax purposes? Wouldn't shareholders sue if the shares go up/down while contrary information is in the public record?
    Reply | Link to Comment
  •  
    Oct 05 11:26 AM
    This problem is not complex nor difficult to understand. This crisis is the
    natural outcome of an extended pyrimid scheme that finally went bust. The only difference this time is that the bad guys got the victims (taxpayers) to pay the piper and they walked away. Even Accounting rules never trump dishonest business practices. If they did we would be in this mess.
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  •  
    Oct 05 01:16 PM


    I do not see anything wrong with the standard. Instead, I see problems with guidance on its implementation.

    Fair value accounting pre-supposes a willing buyer and seller transacting in an orderly market. In such a situation the market value of an asset is indicative of its economic value; thus mark to market rules make good sense.

    When the market is not orderly, I believe the mark to market rule should no apply; a distress sale in a disorderly market cannot be indicative of the true economic value of an asset. Why then should the mark to market rule apply in such circumstances?

    In my view, when application of a standard results in the reflection of a warped picture of economic reality, a true and fair view is not provided to the users of financial statements. In such circumstances, the users of financial information would be better served by:

    1. Exercise of professional judgment in estimating the fair market value which should have prevailed had the market been orderly.

    2. Disclosure of historic cost.

    3. Disclosure of mark to market valuations in a dis-orderly market.


    The users of financial statements need to get used to looking beyond the recognition in order to take from the financials what they need. We live in a far more complicated world today, and just as I learned to use computers, users of financial statements must learn to read them.
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  •  
    Oct 05 01:36 PM
    User 272508: The perceived investor's insistance on simplicity of company reports is an assumption that's never been verified. If it's a harmless myth, then I have no problem. But it's harmful if it reaches a point where simplicity becomes over-simplification. Investors will need, and indeed WANT in my case, to deal with reality rather than some artificially simplified "one number".

    The divergence of the two numbers, mark-to-market vs mark-to-history, should be a warning signal. If mark-to-history is much lower, it means the company's assets have appreciated a lot recently. While it's a good thing for now, investors (and management) should give it a second look. If mark-to-history is much higher, investors will need to scrutinize it and decide whether mark-to-market is meaningful.

    More importantly, the comparison of the company-specific divergence and the market provides a gauge for assessing the company's assets and exposure.

    As to tax, my opinion is that it should be based on realized gain/loss only. Neither mark-to-market nor mark-to-X is relevant.
    Reply | Link to Comment
  •  
    Oct 05 01:36 PM
    User 272508: The perceived investor's insistance on simplicity of company reports is an assumption that's never been verified. If it's a harmless myth, then I have no problem. But it's harmful if it reaches a point where simplicity becomes over-simplification. Investors will need, and indeed WANT in my case, to deal with reality rather than some artificially simplified "one number".

    The divergence of the two numbers, mark-to-market vs mark-to-history, should be a warning signal. If mark-to-history is much lower, it means the company's assets have appreciated a lot recently. While it's a good thing for now, investors (and management) should give it a second look. If mark-to-history is much higher, investors will need to scrutinize it and decide whether mark-to-market is meaningful.

    More importantly, the comparison of the company-specific divergence and the market provides a gauge for assessing the company's assets and exposure.

    As to tax, my opinion is that it should be based on realized gain/loss only. Neither mark-to-market nor mark-to-X is relevant.
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  •  
    Oct 05 01:48 PM
    Shiv, mark-to-cost is a no-go IMO. It's even more misleading than mark-to-model. It's just too unrealistic and can lead to many abuses. Mark-to-history, on the other hand, still relies on market price, with only two necessary adjustments:

    1. Time decay -- cashflows since historical prices, other known changes such as pre-payments and defaults, shortened time to maturity.

    2. Forward discounting

    Balance sheet cannot leave any wriggle-room for "professional judgment", otherwise what you get is professional abuse.

    I agree with your other points, though.
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  •  
    Oct 05 02:12 PM
    Just mark to what you know at the starting line:
    Only politicians have the option to borrow first then borrow again to cover if it goes bad.

    In the real world it's the opposite: If a home is your entry dream to the middle class, you don't get the home out of thin air (from your local politician) then look for a job to pay for it.

    The first step--wherever you're sleeping, buy an alarm clock; now you're ready for a job!. Work and save for at least a few months--just to see if it fits into your lifestyle; If so NOW buy the home.

    If you put in an honest application and have no problems, you might even be able to pay for it.

    Now you have marked yourself to middle class value--not like the Govt. which does it backwards.
    Reply | Link to Comment
  •  
    Oct 05 02:32 PM
    I imagine a world where Bear had no required more collateral of Thornberg.
    Reply | Link to Comment
  •  
    Oct 05 02:57 PM
    Margin call is an interesting question since it conceivably has the same negative effects as Fair Value Accounting.

    For individual brokerage accounts, it's simply not feasible to do individualized analysis. There're just too many cases. A cross-the-board rule is the only option. For big accounts such as hedge funds and bank clients and counterparties, it is feasible to do per-case analysis and make per-case decisions on whether to issue margin call or not. In fact, banks do this all the time for their biggest clients and counterparties.
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  •  
    Oct 05 05:09 PM
    Imagine "Mark to Market" as a tax assessment rule. What would the total value of taxable property be today in Galveston, Texas? Answer, the City would be bankrupt in a New York minute. That is the same as Bo Peng's analogy of assessing the value of a car in a temporary gas shortage. The difference in the financial markets is that many "0" market valued mortgages and derivatives are still paying off, even as they are written off under M to M rules. No deliberate sabotage of our financial system for creating long term damage could have been more devastating than the M to M rules. Imagine the fine institutions that have been sacrificed in the name of this farce! Oh, I guess we don't have to imagine, do we? Leaving M to M rules intact, removing the SEC ban on short-selling as of October 8th, and Congress passing a $900 million subsidy for retooling oil refineries. Each of the policy-makers who are making these decisions is depriving some poor village of an idiot!
    Reply | Link to Comment
  •  
    Oct 05 07:39 PM
    At one time, one could not remove certain assets from ones balance sheet at all, ie. "free will" and carried real estate on the balance sheet at the purchase price (no mark to market there). However, the mark to market rule on long term assets makes not sense. Discount the cash flow and one can fine a more "rational" value to an asset. We used the dividend discount model for years to evaluate the value of stocks. In addition, the naked shorts and the discarding of the up-tick rule is just greed by the uncontrolled markets. This whole thing simply smells of greed and disregarding of the real investors.
    Reply | Link to Comment
  •  
    Oct 05 09:36 PM
    So you're saying that companies should be allowed, no ... encouraged, to account for assets that are utilized as collatoral in a manner that is much greater than their current worth?

    It's crazy, stupid, immoral, and crooked. If a system is built on a house of cards you can't prop it up with more cards because eventually it will fall and the longer it takes the harder it's going to be. I suspect the fall we're about to take will be very painful ... since it's been propped up way too many times already.
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  •  
    Oct 05 11:32 PM
    Let's just imagine for a second if homeowners were subjected to a margin call on their home if their equity drew down to some imaginary figure in the sand.
    Heck, many people who bought since 2004 are already owe more than their loans now. Their homes would have been repossessed before now.
    Clearly, one would have to put at least 20% down in the first place which is a reasonable rule. But if a year later their home dropped in value and their equity dropped to some predetermined level in the sand, they would either have to sell at a loss or put more money into their home. Surely, home values would plunge as fewer would be willing to take on the added risk to their capital. People would complain that real estate is a pretty illiquid market and market values can sometimes be hard to determine in an illiquid market. Its not fair! And they would be right.
    So what are we doing
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  •  
    Oct 05 11:54 PM
    Here is an even more important way of looking at mark to market. If we keep this standard, financial firms will surely adopt policies in the future where they are practically immune to anything like this happening again.
    Yes, this is good! I find it hard to argue with that, but don't be so foolish as to think that keeping this accounting standard will not change the financial marketplace forever. What do we have to lose?
    How about a larger spread between like-maturity treasuries and mortgage rates? I don't see any other way. That will also surely slow economic growth.
    We can't fool ourselves to think that the market for mortgages will be anywhere near as accommodating as it had been even before this decade began.
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  •  
    Oct 06 12:23 AM
    There are too many over leveraged positive feedback loops in the stock market. Short selling is one and should also be stopped forever. There are just too many over educated, moral less (and maybe immoral) financial people in all areas of finance. They think they know better and crisis is what we got. KISS applies here too.
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  •  
    Oct 06 01:22 AM
    StateofConfusion, I strongly disagree with banning shorting. It helps improving market efficiency and keeping companies honest. The positive feedback created by massive shorting will be, and have been, limited as long as the company fundamentals are good.

    Naked short is another story. It creates float out of thin air. Stock is like currency for the company. While you cannot control directly how others value your currency, you at least must have control over its supply. How would you think if country XYZ starts selling massive amount of phantom USD and keeps on it?
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  •  
    Oct 06 02:01 AM
    Somehow, when a bubble was created in the housing market with low fed rates and everything went up, up up, including Banks marketed to irrational assets of the bubble, no one seemed to be complaining that marked to market was a bad idea because it was making extra money for them... So when things go south, just change the rules to make it "fair"

    I find it criminal that the SEC changes their rules on mark to market just before King Henry gets the nod to start buying bank assets with taxpayer money. Instead of moving in at fire sale prices with a chance to actually make money for the US taxpayer, they change the rules so the US taxpayer will be paying retail rates for firewood at a fire sale! Why is not someone going to jail? This will only cost the US taxpayer something like a few hundred billion dollars extra...Oh yea, I forgot, King Henry used to run one of those banks and people like Gramm and Rubin are whispering into the two candidates ears as advisors.. Sage George Bush was quoted about ten days ago as saying "This sucker could go down." Well, now it looks like it will and the bankers are going to help themselves to all the money they can on the way down..

    Don't ever call this a Rescue Package, it is a bailout.
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  •  
    Oct 06 03:37 AM
    I agree, Mark-to-Market clearly ought to be Mark to a fairly long moving average. Earlier this year, mark-to-market rendered the income statements of gas producers such as CHK and DVN meaningless as natural gas prices spiked way above option collars and they were forced to recognize future losses on options. Now that gas prices have come down they will reverse all those imaginary losses.

    It's ironic that the option collars that were put in place to ensure stability for the businesses produced unrealistic gyrations in their financial statements thanks to insane mark-to-market conditions. This hardly seems helpful.
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  •  
    Oct 06 01:24 PM
    The margin call example doesn't fit here. Assets (generally stocks) in a margin call have a market and a market price. It may be unjustafiably deflated but it's there.
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  •  
    Oct 10 07:36 PM
    It is really a mafia rules. My property value went up the assessment of course went up and my taxes went into the sky. Now my property value is down and I can not find renters. The tax is still in the sky. Is that fair. I am sure the Mafia is more kind than the state and the county Government. What kind of sense does this make?
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