There’s been a bit of controversy about Mark-to-Market accounting rules for banks (look here or here). The powers that be will probably reach a verdict on this soon. I just wanted to share a few thoughts.
You might not know what Mark-to-Market accounting actually is and why it might cause problems. Put simply, the rules say that a bank should value their assets at “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” (from FAS 157 via wikipedia). In other words: the market price. There are a few hitches. What happens if the market is illiquid? If nobody is trading a certain asset (think of how you’d assign a market value to the Statue of Liberty), what is the market value? You can get bids, you can show some correlation to another asset (maybe a lot of smaller statues have been selling, and the Statue of Liberty tracks their value times a million), or you can build some fancier model of prices.
Let’s look at an example: Let’s say the asset is a bond. Bonds can be traded, or they can be held to maturity (unlike stocks, which can only be traded). Let’s consider how we’d price a bond if we were holding it to maturity. Since a bond represents a loan, the value of the bond is the value of all remaining payments to be collected, minus some value to represent the fact that cash today is more valuable than cash tomorrow. Assessing the value of all remaining payments to be collected can be tricky: what happens if the borrower goes bankrupt? Well, that gets thrown into the price. What’s the value of the bond if we sell it? If the bond is one of a billion similar bonds, and those bonds trade every day, we can actually know this value by looking at the last trade (or, we could look at any outstanding bid prices). In fact, it’s probably the same as the value that we just assessed for it assuming we’d hold it. Sometimes the two values differ, the mark-to-market rule would tell us to take the latter price. Actually, the rules have provisions to allow us to use the former price, but it requires that we declare that you won’t sell the bond (you will hold it to maturity).
Why does this matter? The banks are saying that some assets aren’t trading every day, or that they are only trading in distressed markets. Specifically, the mortgage backed securities that are at the heart of this economic debacle are weighing down balance sheets. Alternatively, you might think it was ridiculous for a bank holding what was clearly a bubble asset to value the assets at the inflated prices. You might argue that if the bank actually tried to sell the assets, that the bubble would burst, and the value should be accounted for using something other than the current market price. Incidentally, the claim that these mortgage backed securities are illiquid is false. The claim that the market is depressed might have merit, but recent studies have shown reason to believe that even the “distressed” market is overvaluing these assets. Since this is actually the motivation for the current debate, it is relevant, even if there are reasons to change the accounting rules outside of the current crisis.
The argument for mark-to-market accounting is generally led by investors and depositors: they want to have transparency on the valuation of a bank. The market is the clearing mechanism and is the only known way to determine prices. The assumption is that market prices are the most transparent way to value something. Transparency is a generally desirable thing[1].
Without getting too philosophical, the debate is largely hinging on the question: What is the price or value of something? I say “price or value” because the two can be different. If I sell you an apple for a dollar, it’s clear that I valued the apple at a dollar at most and you valued the apple at a dollar at least. I don’t actually know how you value the apple and you don’t know how I valued the apple. We did agree on the price. However, the last price isn’t necessarily the best way to value things. Just because you bought one apple for a dollar doesn’t mean that I can sell a zillion apples for a zillion dollars. But that was the mark-to-market price. It’s probably obvious, but the liquidation price of an asset is almost guaranteed to be lower than the mark-to-market price. But, if we back up a bit, it should be clear that the banks value their assets at more than the mark-to-market price of their assets. If they didn’t, they would have sold them.
When you consider these things, it seems almost ridiculous to require a single number. If I had to try to “fix” mark-to-market accounting, I would probably go about doing it by augmenting it rather than replacing it. It’s useful to know the last price for an asset, but it’s not necessarily the value of the asset (it’s the last point of intersection of the values assessed by two parties). However, if that’s an unacceptable way to value something, I think that a bank should be allowed to state where they differ and why they differ in their valuation. And that’s the punchline. The devil is in the details (and it’s a big devil), but it should be possible in principle to maintain transparency and provide “better” valuations. Again, since different parties will place different values on things, it’s not clear that there really is a “better” valuation. It’s important to recognize that if you want to understand the current debate.
I’ve made some simplifications here, so don’t use this as a strict explanation of the situation. For example, the bid price can differ quit a bit from the last trade price in illiquid markets, and the accounting rules prefer the former over the latter. I actually do have some formal training in accounting, so it’s particularly important that I provide some sort of disclaimer.
[1] A bank might argue against transparency on the grounds that the value they provide is contingent on their proprietary investment strategy. This also makes the debate more complicated.
