The $700 billion bailout package—re-branded with a long title—The US Economic Emergency Act of 2008 (the “Act”) establishing the Troubled Asset Relief Program (the “Program”)—contains a short clause that could have significant impact on banks and the economy. We’re referring to a possible change in an accounting rule that addresses mark-to-market accounting (MTM).
Amid the heated congressional debates over the bailout’s pros and cons, both sides of the aisle liked the idea of suspending MTM. Tucked away in the final plan is a clause calling for a study of mark-to-market accounting, but doesn’t actually require suspension. The final plan does grant the head of the SEC the power to suspend the rule.
Before your eyes glaze over, we’d like to explain in the simplest terms possible, what this accounting rule is, and why it matters more than anyone might think.
The fundamental idea behind mark-to-market accounting (sometimes referred to as “fair-value accounting”) is to make financial statements fairly reflect the current financial condition of a company. Broadly speaking, it is an effort to make financial statements more “transparent” for investors, lenders and others who depend on financial statements when deciding whether or not to invest or lend to a company.
Mark to market accounting means that you value ("mark") your assets at their market price. Now that’s a no-brainer when we’re talking about shares of Intel—plenty of investors are buying and selling those shares, so it’s easy to know what the market price is. But what happens when you try to place a value on something for which there is no active trading market? Like a factory building, a brand name, or a house.
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A Hypothetical Case
Here’s a hypothetical example. When you ask a real estate agent to estimate the value of your home prior to putting it on the market, where’s the first place they look? They check recent home sales figures from your neighborhood and try to come up with a reasonable estimated value. This system works reasonably well under normal circumstances. But when the mortgage crisis hit the system got knocked for a loop.
Nobody wants to sell in a down market if they don’t have to, so fewer homes are being sold, and those that do sell, trade at depressed prices. Running sales comparisons to arrive at a fair market value in that kind of volatile environment suddenly doesn’t seem very fair. Arriving at a fair market value, as it is called, is like shooting at a moving target.
For those homeowners who are in for the long haul with fixed rate mortgages, sudden price fluctuation doesn’t present that much of a problem. But what if creditors expected everyone to keep track of the value of all their assets, and to keep that figure in balance with all their debts? In other words, they would expect you to create and live in accordance with a mandated personal balance sheet. What then?
For the sake of simplicity, let’s say the total current value of all your assets, including your home is $500,000. The total of all your debts including credit cards, car loans and mortgage is also $500,000. So far, so good.
But because of the mortgage crisis, the whole real estate market is affected and the value of your home goes down. Since your assets have now been reduced, your asset/debt ratio gets too low, and you’re forced to sell something in order to bring everything back into balance.
If such a scenario were real, and if enough homeowners were forced to sell the houses, the effect would be like knocking down dominoes. At the core, this hypothetical scenario is exactly what some claim is wrong with MTM accounting.
Mark-to-market accounting forces banks to honestly disclose what they own and how much their investments are worth on any given day, and that could include billions of dollars in mortgage-related securities held on their books.
Some experts argue that MTM is the underlying cause for the credit crisis. Others worry that changing the rules now would make it tougher to come up with a bank's real value and would just sweep the problems under the rug and shake investor confidence even more.
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The Critics Weigh In
Avinash Persaud, a financial analyst who is published widely in academic and professional journals, spoke during the annual IMF/World Bank meetings on October 12 in Washington D.C.
He said, “The problem with mark-to-market is, basically, not that assets are valued in a certain way, but that firms are required to do certain things as a result of those valuations. The argument against mark-to-market is that we think they should not have to do those things.
Persaud argues, “There are two ways to allow firms not to sell their assets in response to low market prices. One is to stop asking firms to reveal the market value of their assets; the second is to change the requirement that they sell those assets whenever their asset/debt ratio gets too low. The second seems obviously preferable: it solves the problem directly, while allowing us to have as much information about the companies we invest in as possible.”
While the possible end of MTM is making some critics happy, it doesn't satisfy everybody. Some are concerned that if the rules change and banks and Wall Street firms can suddenly recreate “better looking” balance sheets, investors will have even less confidence in these firms because their true financial situation will be obscured.
Others argue that any benefit in the rule changes for banks and Wall Street firms may not amount to as much as some assume since much of the writedowns have already occurred. And certainly it's too late to save the large financial institutions that have already collapsed because of bad mortgages.
"I think mark to market is seen as a panacea, but I don't think it's that simple," said Brian Gardner, the Washington analyst for KBW, an investment firm that focuses on the financial services industry. "I don't think it's as big a deal for a lot of the banks."
The Standard-Setters Step In
On October 7, it appeared that the Securities and Exchange Commission (SEC) and the Financial Standards Accounting Board (FSAB) were changing course on the rule by publishing new guidelines for financial firms. The two organizations said when the market for a security disappears it is now allowable to arrive at a value using "estimates that incorporate current market participant expectations of future cash flows, and including appropriate risk premiums is acceptable."
In other words, banks may not be forced to take huge writedowns on investments that are virtually valueless. While still only presented as “guidance,” the SEC and FASB reserved the right to take more definitive steps to change the rules in the future.
David Larsen, managing director at financial advisory firm Duff & Phelps believes that even with the new guidance from the SEC and FASB, it's not clear if accountants and chief financial officers are going to be able to ignore the sharp drop in market value for MBS pools in the current environment.
"To try to put a genie back in the bottle and go backwards from a transparency point of view makes little sense," said Larsen.
So, which is better, keeping MTM or changing the rules? Not everyone agrees on the answer, but one fact everyone agrees on is that the current financial crisis centers on the mortgage loans worth trillions of dollars that were packaged together into mortgage-backed securities, and sold to banks and Wall Street firms.
And as we know, home prices fell, foreclosures rose and the value of those risky securities was reduced to such a degree that there is virtually no market for them. It remains to be seen what effect, if any, the potential future rule changes will have on the economy at large.
