Should ‘Mark to Market’ Meet Its Maker?

Journalists probably have a secret rule of thumb that says you lose half your readers every time the phrase ‘accounting rule’ appears in an article.

For the half of you who are still with me, let me try to inoculate you against this natural human inclination by pointing out that this week may be the only time in your life that a debate about an accounting rule is a front-page issue: The revised version of the financial market revivification bill being considered in Congress instructs the Securities and Exchange Commission to think very hard about relaxing its rule requiring certain financial institutions to ‘mark to market’ all of the assets on their books. So, if there is any moment in your life to exercise your willpower and force glazing eyes to unglaze, this should be it.

The quarter of my initial readers who are still with me will be relieved to hear that the debate is actually more interesting than they might imagine. The question at issue, fundamentally, is whether markets can be trusted to always set a rational price for an asset.

The wise assumption of the ‘mark to market’ rule is that the banks themselves cannot be trusted (I use ‘banks’ loosely, as a substitute for ‘financial institutions subject to the SEC rules discussed above’). The rule requires banks, whenever possible, to count an asset’s value as being the same as the value of any similar asset that has recently been traded between two arms-length players in the market. So, if party A just paid party B $100 for a given asset, then an identical asset owned by party C must be marked as also being worth $100, even if the original sticker price was, say, $1000.

Our front-page controversy right now is about what to do when the market for an asset has largely or entirely collapsed, as has happened for the ‘toxic waste’ mortgage-backed securities that are now a lively part of our national discourse.

The question is undeniably complex, because there are several potential explanations for the market collapse.

One explanation is reminiscent of Groucho Marx’s remark that he wouldn’t want to be a member of any club that would accept him as a member. If a bank that is holding several mortgage-backed securities (‘mortgage pools’) knows that mortgage pool A consists of mortgages that were made to people who definitely won’t pay them back, and pool B is mortgages to people who definitely will repay, then it wants to keep pool B and dump pool A. So the very fact that it is offering A for sale is ipso facto proof of A’s toxicity. (Two Nobel prizes have been awarded, to George Akerlof and to Joseph Stiglitz, for figuring out how to make this point mathematically. Sadly, Marx never received the economics Nobel he deserved, which is perhaps just as well given the endless confusion this might have caused for the political left).

Another possible reason for the market to have collapsed is (slightly) more benign. Maybe the problem is simply that, to continue with the cinematic allusions, ‘nobody knows anything.’ In the end, each of these securities will turn out in fact to yield some stream (trickle?) of revenues, as the borrowers either make their payments, refinance, or default. But perhaps no information in anybody’s hands right now can yield a believable prediction about the proportion of borrowers who will choose each strategy. ‘Knightian’ uncertainty (after the economist Frank Knight) was recognized as a difficult problem in economics long before Donald Rumsfeld started making oracular pronouncements about ‘unknown unknowns.’

The reason the ‘mark to market’ rule is suddenly headline material is that the collapse of the market for asset-backed securities threatens to force banks to write down some of their assets to much lower prices than they were bought at. Since banks are required to have a certain minimum amount of capital (assets minus liabilities) before they can lend, if their assets are marked down sharply then they may be forced to stop lending.

Secretary Paulson’s plan fundamentally asserts that if only we can force a large proportion of these assets to be publicly traded, they will find a price that is much higher than the low valuations at which consenting adults have exchanged them in recent weeks and months. This might turn out to be true; but it requires a considerable leap of faith.

Repealing the ‘mark-to-market’ rule might seem to be a much more predictable way of accomplishing the same thing; if, for example, banks were allowed to pretend that their subprime securities were still worth what they paid for them, then those nasty regulations requiring them to have ‘assets’ that noticeably exceed their liabilities might no longer bite.

This sounds plausible, but it is almost surely a delusion. The reason banks are increasingly unwilling to lend to each other (as indicated by the spike in the suddenly-famous LIBOR rate) is not that they are all deluded by some silly accounting rule whose implications they all perfectly understand (for each other, as well as themselves). They don’t want to lend to each other because each bank thinks the other bank’s subprime assets might actually, really, truly, be worthless.

In the end, the idea that suspending mark-to-market rules would solve all our problems is probably best interpreted as just part of the ‘denial’ stage of our grieving process for the capital market conditions of a year ago (or 10 minutes ago).

It is vital that we move beyond this denial stage as soon as possible. Our crisis is truly not very different from those experienced by many other countries (even rich countries) in recent decades (America may be exceptional in other respects, but a bank crisis is a bank crisis is a bank crisis). At the stage of a crisis that we currently inhabit, denial is always deeply appealing, especially to the bankers and their allies. But those countries who have succumbed to this siren’s song have paid a very steep price. (Japan is the poster child for denial; it suffered ten years of denial and stagnation after the collapse of its asset bubble in 1990).

A powerful impulse to deny reality may be a natural human emotion in response to an unpleasant shock. But if we don’t want to further impoverish ourselves, we need a rational, not an emotional, response to our financial meltdown.

9 Responses to "Should ‘Mark to Market’ Meet Its Maker?"

  1. Vitoria Saddi   October 3, 2008 at 8:39 am

    Chris, Fully agreed. It’s been said that we are in the first of the five stages of grief. I agree that the end of the market to market will not solve anything and hence lack of trust among banks continues. My question to you is:- Assuming that this is not the first systemic banking crisis we have seen and assuming that a few of major banking crisis in the past had IMF support why can’t the US ask the IMF for help?

    • Mark K. Braswell   November 14, 2008 at 11:49 am

      I am posting this comment at the invitation of Chris Carroll, a friend of 25+ years. I write not as an economist or an accountant (I am neither), but as a securities lawyer who investigated and prosecuted a number of accounting frauds while working for the SEC’s Division of Enforcement in Washington, D.C. (1995-2003). Since returning to private practice, I have often found myself in the role of “translator”, trying to convert accounting-speak into securities law legalese and then (hopefully) into plain English.Let me offer a preview of my thoughts by saying this: the notion that regulators or accounting standard-setters should change accounting standards mid-game strikes me as a remarkably bad idea. Changing the rules mid-game will not put confidence back into the markets; it will only further erode it. On its face, any attempt to modify a rational rule set in response to irrational market behavior is pure folly.In talking about this, however, commentators, myself included, need to exercise more clarity. The debate right now is over so-called “fair value” accounting for privately issued, illiquid assets, something economists might call “mark-to-model” valuation, NOT the abandonment of market-based valuation of marketable securities. That’s a big difference, and part of the confusion rests with differences in the way lawmakers, accountants and economists use the term “mark to market.”Securities laws and accounting rules have always required publicly traded financial institutions to state assets “at value.” For the longest time, “value” was simply defined as “the lower of cost or market” which sounded conservative but in practice meant that private securities were always carried at cost because there was no “market” to mark them against. Fair value accounting is an attempt to get financial institutions to mark these non-marketable assets at an estimated value other than cost. The Financial Accounting Standards Board’s new “fair value” rule became generally applicable to all public companies in November 2007, a few months after the sub-prime crisis first made national news. A year later, fair value rules are poorly understood, both by investors and by financial institutions that must now apply them. A number of commentators are now suggesting that the new rule has contributed to the current turmoil in our capital markets.The commentators have a point, but the solution offered, i.e., to roll back GAAP accounting rules on fair value, is a singularly bad idea.The answer to irrational market behavior is more transparency and more investor education, not the repeal of rational, well-vetted accounting rules. That’s where Congress, the SEC, the FASB and others should focus their efforts.As we move into a new U.S. administration and serious overhaul of our piecemeal regulatory framework is finally brought front and center, I hope the emphasis will be on providing more financial transparency, not less, to the markets.Stay tuned …

  2. s gerber   October 3, 2008 at 10:06 am

    It was Groucho Marx, not Woody Allen, whom you are quoting.

    • Guest   October 3, 2008 at 1:32 pm

      (Sorry, you’re right, the piece is now corrected to refer to Groucho Marx instead of Woody Allen).

  3. Takeo Hoshi
    Takeo Hoshi   October 3, 2008 at 11:40 am

    Hi Chris, A great post. Repealing of “mark to market” rule is exactly what happened in Japan. Well, they didn’t have mark to market, but they were in the process of introducing it, and they decided to introduce that selectively to help banks continue to hide the true financial conditions. In 1998, the banks were allowed to mark the value of their land holdings to market (market value was greater than book value for land) and to continue to use book value for their share holdings (market value, by that time, was smaller than book value for stocks that banks owned).

  4. Eve   October 4, 2008 at 1:33 am

    Dear Prof Carroll:My eyes have indeed glazed over every time I sawa reference to mark-to-market, but I knew it wasimportant to understanding whats going on. Yourarticle was a clear and to-the-point explanationthat a non-specialist like me could understand (and even enjoy reading). And even you didnt know thatyou are a bit of a (Groucho) Marxist. Eve

  5. Becky Blair   October 5, 2008 at 10:34 pm

    Chris,The Mark to Market rule is actually the same method banks used to value homes for sub-prime mortgages. Banks would look for the highest value of a property in the same area of the subject property that was being sold. The value of the home being sold became the identical value of the highest price recently paid in the same area. All values are NOT the same! This method of value will skew prices and drive down home sales further. I agree with you that Bankers are still in denial. The sooner Banks accept their situation and turn to a free market solution, the better for all of us.

  6. Anonymous   October 6, 2008 at 3:28 pm

    Chris,Accountants (and regulators) force banks to recognize impairments on assets held at historical cost. This can be done in a smooth, and relatively predictable fashion. Mark-to-market injects volatility unnecessarily. If investors could see through financial statements to the underlying economic reality of a bank’s position, it wouldn’t matter, but they really can’t.Example: bank A has $100 of loans, all of which are current and were originated at par. Valuing these at historical cost would yield an asset value of $100. If the accountants, following a methodology laid out by FASB and the regulators, determine that a loss has been incurred, the bank must increase their loss reserve (effectively subtracting the reserve from the value of the asset). Suppose that the methodology determined that the reserve should be increased by $2, perhaps because home values have decreased to a point that indicates that default probabilities over the next period of time have increased. The loan book would effectively be written down to $98.Now, consider the impact of moving to mark-to-market. Suppose on the last day of the quarter that liquidity dries up, and the few similar loans that move trade at $90. Mark-to-market accounting would force the bank to value the loans at $90, even though all of the underlying loans are current, and even if the price move were reversed the next day. If the bank intends to hold the loans to maturity, there is no sense in re-valuing them at a high frequency.There clearly are cases where mark-to-market is the right paradigm. An asset manager who intends to trade the loans (or securities) at a high frequency should be forced to use mark-to-market, as it represents the potential realizable value if they were forced to sell on any given day.The accounting rule changes in recent years have disfavored any accounting using historical cost and have leaned to mark-to-market in most situations. As you might expect, this discourages hold-to-maturity investing and encourages trading activity. Not the basis for a stable financial system.Waanon

  7. buysell   October 16, 2008 at 4:50 pm

    Chris,I had my home listed for sale recently. The listing agent said I must go by the CMA (comparative market analysis) or my house won’t sell. Despite the agents urging me to drop the asking price, I stuck by my price. Now is a bad time to sell, so I’ll wait.When looking to buy, the realtors have a different tune. I’m told the price of recently sold properties is not a fair comparison. In fact the realtor I’m using now to look for another home, doesn’t like to talk about the fact that home prices are dropping like a rock.I’m asked to sell my home at $120,000, while the house next door just foreclosed for $330,000. So when selling I need to look at $120, when buying I need to look at $330?I say keep mark-to-market, keep the government out, and let this whole mess correct itself.