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Tuesday, November 18, 2008

How Much of a Role did Mark-to-Market Accounting Play in the Credit Crisis?

Not many people outside of the financial world would consider the possibility of a technical accounting rule playing a role in the credit crisis. Unfortunately, it takes a crisis of this magnitude to bring these concepts to light.

In a nutshell, mark-to-market accounting assigns the current market price to a held financial instrument. For example, if you buy 100 shares of XYZ Corporation’s stock at $10 per share, the value of your shares would be worth $1,000 (100 shares x $10/share). Six months later, the stock is trading at $20 per share. The “mark-to-market” value of the stock would now be $2,000 (100 shares x $20/share). By employing mark-to-market accounting, the net worth of your asset just doubled. In the simplest terms, this practice makes sense. The current value of the stock should be recorded on a company’s books regardless of whether this affects their balance sheet positively or negatively. However, there are two things to consider: 1) potential for major abuse when applied to more complex financial instruments – especially debt instruments and 2) how both realized and unrealized gains/losses affect the market’s perception of an entity.

The Financial Accounting Standards Board (FASB) issued Statement No. 157 in November 2007 with the intent to establish a framework for measuring fair value in generally accepted accounting principles (GAAP) and expand disclosures about fair value measurements. (1) FAS 157 established a hierarchy of asset classes which attempts to assign values to assets that are not as liquid as a stock that trades on the market everyday. In other words, how is a value assigned when it cannot be assessed by its current trading price? The trade value of a stock can be verified at any time, but what about financial instruments that do not trade in the market on a daily basis? Assets are broken down into three levels:

Level one: consists of assets that have an identifiable market price (price of a stock that trades on the market).

Level two: is a class of assets that do not have market prices. A model is then constructed to determine the assets’ fair value. Some inputs include but are not limited to prices of similar securities and interest rates.

Level three: is comprised of assets that don’t have market prices, and the valuation techniques used to price “level two assets” are not available. As a result, an entity is allowed to use its own assumptions bearing in mind that the asset should be priced based on what a willing buyer would pay.

The analogy behind the level three asset classification is what gives what gives way to the famous term “mark-to-make believe.”

The value of mortgage-related securities relies heavily on assumptions – assumptions that had a positive effect during the housing boom, but now have a very negative affect as banks are now recognizing billions of dollars in losses.

What happens when investors panic and sell? What assumptions can be used to value financial instruments being sold in mass panic? This is where things get murky. Assets being sold out of panic make it extremely difficult to assign value. In addition, the inputs that are used are nothing more than educated guesses by accountants. What a way to halt trading in the market when things go astray! The problem with many valuation techniques is that they overstate the value of assets, which then overstates losses.

Mark-to-market accounting also wreaks havoc on the liability side of things. Bond prices are inversely related to the company’s risk. In other words, if the price of a bond falls, it is in response to the market’s perception that the company’s risk has increased. Think Goldman Sachs and Lehman brothers here. Mark-to-market accounting allows these entities to record GAINS on their income statement. One may ask why on Earth they would be allowed to do this. For those who stayed awake during Accounting 101: remember the basic accounting equation? Shareholders’ equity = Assets – liabilities. When the value of the bonds decrease, the result is a decrease in total liabilities which means shareholders’ equity INCREASES…hence the gain. It’s a wonder how Lehman Brothers was able to report $2.4 billion in pre-tax profits by “marking to market” its liabilities. Then, shortly after the collapse of the market bubble, the company is bankrupt. (2)

In summary, the FASB and the Securities and Exchange Commission should rethink the use of mark-to-market accounting in publicly traded companies. Perhaps it should remain only in the futures exchange where the practice originated. Accounting should be uniform and give a conservative, accurate picture of where an entity stands. There are too many unknown factors, and blind assumptions are made when applying valuation techniques. This gives way to artificial market bubbles and extreme volatility when the bubbles burst. If entities are able to use mark-to-market accounting which allows unrealized gains to manufacture synthetic profits which then quickly spirals into realized losses, the housing bubble and burst will the first of many in the future.


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