| Understanding How Mark to Market Rules are Fueling the Credit Crisis |
Accounting Rules Can Hurt Many Wall Street executives and investors have been complaining about the mark to market accounting rule---blaming it for the massive declines in company values and stock prices of many financial firms.  Former FDIC Chair William Isaac put it this way in an interview on CNBC, "The SEC has destroyed $500 billion of bank capital by its senseless marking to market of these assets for which there is no marking to market, and that has destroyed $5 trillion of bank lending," he said. "That’s a major issue in the credit crunch we’re in right now. The banks just don’t have the capital to start lending right now, because of these horrendous markdowns that the SEC’s approach required." The Mark to Market rule is an accounting rule that requires financial institutions to mark, or adjust, the value of their marketable securities---like mortgage-backed securities---to their market value, which is determined by the last price at which a security was sold. For instance, if a financial institution bought a mortgage-backed security for $100, that security would have a value of $100 on the books of the company. In other words, the company would be able to report that it has an asset worth $100. However, thanks to the mark to market rule, the value of that mortgage-backed security, or asset, on the company's books is going to fluctuate. If similar mortgage-backed securities begin trading for $110 a piece, instead of $100 a piece, the company will adjust the value of its mortgage-backed security from $100 up to $110. Of course, the opposite also applies. If similar mortgage-backed securities begin trading for $90 a piece, instead of $100 a piece, the company will adjust the value of its mortgage-backed security from $100 down to $90. Why is the Mark to Market Rule a Problem? The Mark to Market rule can be a problem when the asset writedowns begin to have a negative affect on a company's balance sheet. (A writedown is the process of marking down the value of an asset.) For instance, imagine a financial institution has not bought $100 worth of mortgage-backed securities but has instead bought $10 billion worth of mortgage-backed securities. Now imagine that the market value of those mortgage-backed securities is cut in half. In this scenario, the financial institution would lose $5 billion worth of assets and may not be able to meet all of its liabilities---which would make it insolvent. [For more on insolvent financial institutions, check out What are Zombie Banks?] The real kicker here is that the mortgage-backed securities may actually be worth much more than 50 percent of their face value. But because accounting rules force financial institutions to mark their assets to the current market price, these financial institutions have to show a much larger loss than they have actually sustained. And if that's the case, these financial institutions are grossly undervalued. Arguments for the Mark to Market Rule Of course, many analysts and economists believe the mark to market rule is essential to understanding exactly how much a financial institutions' assets are really worth. In the example above, we showed mortgage-backed securities that had to be marked down by 50 percent. What if those values are accurate? Shouldn't investors know how much a company's assets are really worth? Taking it one step further, what if the 50 percent writedown wasn't enough? What if one financial institution was able to sell its mortgage-backed securities for 50 cents on the dollar---and thus establish a market price that everyone else then had to mark their assets to---but other financial institutions would only be able to sell their mortgage-backed securities for 40 cents on the dollar? Aren't these other financial institutions then assigning a value to their assets that is too high? Conclusion As you can see, the question of whether a financial institution should be forced to mark its assets to the current market value is a difficult one. Currently, the rules state that financial institutions do have to follow mark-to-market accounting guidelines. However, the Securities and Exchange Commission (SEC) has the power to reverse those rules if it so chooses. We'll just have to wait and see.
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3.25 Copyright (C) 2007 Alain Georgette / Copyright (C) 2006 Frantisek Hliva. All rights reserved." |
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