Why We Need More Mark to Market Accounting, Not Less

As of late, there has been a lot of talk of doing away with or at least suspending Mark to Market Accounting.  Many on Jon Stewart’s favorite channel, CNBC,  have blamed it for the banks’ tenuous financial position.  They argue that if we did away with this accounting, the banks would actually look and be much healthier.  Leave aside for the moment that it was the banks’ dumb investments in illiquid residential and commercial mortgage backed securities that got them into this position, not the accounting.  Should we really be looking to suspend, repeal or in anyway minimize the use of mark to market accounting?

Some Background:  Banking regulations and debt covenants require banks to hold a certain amount of capital to meet any calls for cash from creditors or depositors (depositors are really just creditors of the bank with the interest they charge for their loans being the interest paid on deposits).  This capital usually takes one of two forms:  (1) cash or (2) marketable securities.  When a creditor comes to a bank to call in a credit line, to withdraw its deposits, or to simply force the bank to “post more collateral,” if the bank does not have enough cash, it must come up with the cash by selling its marketable securities.

Underlying Rationale for Mark to Market Accounting:  Mark to Market Accounting forces institutions to value certain assets on its balance sheet at the price the institution would receive if it had to sell the asset now.  In order to evaluate the likelihood that it will get back any principle it lends to a bank, a potential creditor will look to see what type of collateral the bank holds .  The collateral that it will look to is the bank’s marketable securities (usually stocks, bonds, mortgage back securities, or CDOs).

If enough creditors make capital calls all at once, the bank may not have enough cash to meet those calls.  When this occurs, the bank will have to liquidate some of its marketable securities.  It then uses that cash to meet the collateral calls.  Therefore, in order to meet the calls, the securities used are only worth what the bank can get in the open market.  Currently, the markets for many of these securities, especially mortgage backed securities, do not exist or puts a price of 20-30 cents on the dollar (regardless of current performance).

How Does Mark to Market Accounting Effect Capital Requirements:  Certain regulations require that if the assets that a bank might use to meet its capital requirements drop in value, as measured by the current price in the market (marking to market), the bank must record a loss on its income statement.  This will lead to less capital appearing on the banks balance sheet and force the bank to either (1) post more collateral to its capital account, or (2) raise additional capital in the market either by selling shares in the bank or getting a loan.

What opponents of mark to market argue is that the current price of these securities does not represent the “true” value of the securities.  Rather, the securities should be valued based on future cash flows.  Mr. Kudlow, in particular, argues that many of these debt securities actually have much higher “true” value, because the debt payments are currently being made (i.e., the securities are cash flow positive).  He argues that the banks are not actually losing money currently, because the payments are being made.  If held to maturity, he asserts, the securities will pay much more money than the current market price is implying.  He argues that the banks should not be forced to record losses on securities where those securities are current on their payments; he advocates that we should be valuing the securities based on a discounted future cash flow model.

But as John Maynard Keynes said, “in the long run, we are all dead.”  A bank’s creditor does not care that these securities, in the future, will return all the money lent.  All the creditor cares about is getting its money back NOW.  Mark to Market accounting allows creditors to evaluate whether, if the bank’s securities had to be “monetized” today,would the cash raised be enough to cover the loan.  Essentially, mark to market exists to protect those creditors who might demand their money back today (not when the bank’s securities mature or come due).

Given that this type of accounting exists to protect creditors, why would we want to suspend or repeal it?  Shouldn’t we actually expand’s its coverage to any security that might ever be used to cover a capital call?

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2 Responses to “Why We Need More Mark to Market Accounting, Not Less”

  1. Michael Says:

    Let’s assume the world was filled with only two types of cars. Honda’s and Toyota’s. Not everyone owned cars. Most people who own cars dont sell them. I.E. there is no market. One car owner sells his Honda because he lost his job for 50% of what he just paid for it 3 weeks ago. Is everyone else’s car now worth 50 cents, just because of one fire sale? Mark to market works when there is a market. When there is no market it does not. Further it is statistically possible based on historical data to determine what amount of trading volume as a % of the total underlying outstanding makes a functioning market. If a market is functioning mark. If it is not – I’m not writing down my toyota because of the unemployed guy who sold his honda at a firesale price.

    • mschonholz Says:

      Michael,

      The “problem” with your hypothetical is that is not an analogy for the bank situation. In your example, you would need market to market if your creditors could force you to sell your car when you did not want onto and on a moments notice. So long as you do not need to sell your car in a fire sale, and could wait until you get the price you want, there is no problem.

      In the banking situation, you only need to worry about what your assets would be worth in a fire sale if a creditor could force a fire sale. If a bank knew that no creditor could call in a loan or force the bank to post collateral for 10 years, the bank would have no problem now if the current prices on the assets decreased significantly. This is one of the reasons banks pay more interest on term CDs–they know that the money is locked up for a certain amount of time.

      But in the real world, depositors can make withdrawals at any time and many lenders to banks can call in their loans on short or no notice. It is these unforeseen situations that mark to market is needed.

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