To understand the importance of the "mark to market" issue that is causing so much anguish in the financial markets ("gasoline on the fire," in the words of Warren Buffett), here's a homely example.
Personal "Mark to Market" Accounting. Let's say a year ago I drew up a personal financial statement in the form of a balance sheet. On the asset side, I have a very enjoyable Picasso portrait passed on by a deceased aunt. Her estate valued the painting at $300,000 and that's what I put in my statement. After making all the other entries, my net worth (assets minus liabilities) came to $200,000.
But I read in the paper today that similar Picasso portraits are now selling for only $100,000. If I updated that financial statement, I would show a net worth of zero. Should I (1) declare bankruptcy or (2) ask a still-alive rich uncle for an immediate cash infusion?
Or (3) should I just go on as if nothing much had happened, continuing to admire the painting every time I passed it. (Although I might advise my future heirs that if the market didn't turn around before I died, the painting wouldn't be as valuable as they had counted on.)
Financial Institutions, Regulators and "Mark to Market." If you are like most regulated financial institutions these days and it's "subprime" mortgage securities instead of Picassos that we are talking about, your choice is generally limited to (2). Of course, there is no functioning market in such securities, so the valuation numbers are guesses, given an air of authority by complicated formulae.
The application of "mark to market" accounting to all manner of assets was intended by the regulators to reduce the ability of managements to "cook the books" by demanding an "objective" and transparent valuation method. But anyone who is familiar with the accounting issues in, say, money market funds, knows how complex and seemingly arbitrary some of these issues can be. Indeed, in many respects, required accounting approaches are as much philosophical or political as they are technical (just ask an energy company executive about accounting for oil and gas reserves).
As explained clearly by Holman Jenkins in The Wall Street Journal, because of "mark to market" accounting, the regulatory agencies consider many mortgage-heavy banks as insolvent, or close to it, and demand that they raise new equity capital (or provide it via the U.S. Treasury, with politically generated constraints). Without this pressure from the authorities, most banks with "toxic assets" could probably earn their way out of the current mess so long as the profit spread between their (government insured) deposits and lending rates remains extremely wide.
It's Called Forbearance. We've been down this road before - in the early 1980s when every major U.S. international bank had a pot full of developing country debt on their books that was in default. Strict application of regulatory accounting rules at that time would have forced several of the majors out of business. The regulators and the Treasury Department decided to look the other way and concentrate on letting the banks earn their way out of the mess (with a little help in the form of renegotiations with the debtors). All the details are in an excellent FDIC paper of several years ago.
Forbearance increasingly seems to make considerably more sense (and drastically reduce taxpayer investment in the banking system) than the current policy mish-mash - which has every would-be investor in new bank equity issues uncertain about how government action will affect their investment.
Bill, let's make a distinction between accounting for regulatory purposes and for investor disclosure. It's the regulators at this point who are insisting, using mark to market accounting, that the banks get more capital. If a bank can make a credible case for not using mark to mark, it should be allowed to do so - for regulatory purposes. At the same time, it may want to also use mark-to-market if investors demand it.
Primus Guaranty, the credit default insurance company, was showing a $1.8 billion negative shareholders equity at the end of 2008, based on mark to market. But it intends to hold these positions to maturity and has substantial reserves to cover prospective losses. Fortunately, they are not regulated by the U.S. government, and I continue to hold a modest profitable position in both their common and preferred.
Posted by: James Burnham | March 12, 2009 at 11:44 AM
I disagree. The "Ostrich Strategy" of simply ignoring market values is far worse than marking to market. What about investors and counterparties? Don't they deserve a realistic view of the bank's current balance sheet? Shared denial and opacity is not a strategy, it's a suicide pact.
Mark to market at least makes an attempt to give investors and counterparties as realistic a view as possible of the current state of a financial institution. But perhaps most importantly, mark-to-market puts pressure on institutions to change. It is the schumpeter-esque destructive force that destroys fundamentally badly managed and or structured institutions (e.g. Citicorp). The Ostrich Strategy just gives a free pass to poorly managed institutions.
The solution is not to ignore reality and let badly managed institutions live on, but to construct a system that allows institutions to fail gracefully no matter how big they are.
Posted by: Bill Burnham | March 12, 2009 at 11:10 AM