Current Problems in Mark to Market Accounting - 3 / 10 / 2009

We are in what some consider to be the worst financial crisis in US History. Many elements previously discussed on this site would be classified either the causes or effects of this crisis. But as we continue to peal back the layers of this crisis, there is one certain phrase that continues to appear, "Mark - to - Market" accounting. What does this actually mean?

FASB and the SEC state that a company must value and state its assets at current or "fair" market value. These changes in asset value must be reported quarterly and audited annually. However, the highest value you are able to report during the entire ownership of the asset is the purchase price. Gains can only be reported after a sale.

So if you have an office building (in a good market of course) that you purchased in 1995 for $2.0 million whose current fair market value if sold would be $10.0 million, that increase in value can not be applied to the assets on your balances sheet. BUT should the value, by fair market accounting standards, reduce at any time during its holding, that unrealized loss, say $500,000 must be expensed through your income statement.

For most companies, this is not an issue because they depreciate the asset over time and therefore can argue that they have expensed the declining asset value sufficiently to guide investors as to the true value of their shareholdings.

But for Banks and Investment Banks that bought speculative asset backed financial instruments that were paying them higher interest payments than they otherwise could have earned with less speculative investments, a down market and a requirement to write down those assets to fair value can be catastrophic. Why? Because as the assets on the balance sheets of banks erode, they reduce the overall net capital (or liquid equity) required to be in place by the US Government in order to be considered "solvent". Equity is determined by Assets - Liabilities. If assets are written down dramatically, you can see how a bank moves closer to or becomes insolvent very quickly.

You can now understand why banks want a suspension of mark to market accounting. Essentially they are asking the government to not recognize bad investment decisions or bad balance sheet management decisions. This way they are able to continue to do business while ignoring their asset values in declining markets making additional government solvency loans (TARP and BAILOUTS) not as necessary, and ultimately allowing them to further leverage their balance sheets in extending business and consumer loans.

Recently, Roubini of NYU Business fame stated that by traditional standards, the top 4 US banks were insolvent. The solution to this insolvency offered by our current banking officers, suspend mark to market accounting.

I hope this strikes you the same it strikes me, the banking officials greatly responsible for the current credit market crisis due to over leveraging of risky assets in an attempt in increase profitability, are now suggesting that the answer is more of the same.

You operate your business and personal lives recognizing that there are risks inherent in assuming debt that future cash flows must cover. You are required to report your losses from investments as they occur. You are the owner, and you recognize that insolvency means total loss of all that you have built. So you are sure that you manage your risks appropriately. Officers of Publicly traded banks it would seem do not have to manage their risks appropriately.

High risk means high return in good economic times. Their bonuses in good economic times are so large, that failure in the future is meaningless to their personal security. These officers, for the most part, have built nothing. They are the stars promoted from middle management. They rarely if ever took risks then. But in 2005 - 2007, newly promoted to executive level, they took huge risks because their personal payouts were huge for taking those risks and succeeding. Guess what, these risks were taken at the expense of their shareholder's futures. And the current crisis is the result.

And their solution is - - -Let us do it again, suspend or eliminate mark to market accounting.
They have no interest in building value. They want to leverage value. When a President or CEO begins to leverage value in order to increase current income it is the first sign that the business has stopped growing. Recognize when you are doing it with your business.

Build value every day.

Brad van Siclen