The Trouble with Market-to-Market

Mar 12, 2009
In The News

Mark-to-market accounting rules were intended to bring transparency and order to the bookkeeping at banks and other large businesses. In theory, the rules are prudent. In practice, the rules are doing more harm than good, and current congressional efforts to reform them deserve consideration.

The problem is this: Under mark-to-market rules, a bank must readjust the value of the assets it is holding to reflect current market prices. For some kinds of assets — especially mortgage-backed securities and other real-estate products — those market prices have declined well past the point at which the banks would agree to sell them. We are reflexively skeptical of any argument that there is a “real price” that is different from the market price, but in this case the distinction is plausible. These assets generate income, and that income makes them worth more to the banks than buyers on the market would currently be willing to pay. Under the current rules, that doesn’t matter, and the assets’ value has to be adjusted to account for what the rules describe as a “hypothetical transaction at the measurement date.”

Real market prices come from the interaction of a willing buyer and a willing seller, but the current mark-to-market rules deform that familiar arrangement into “willing buyer, unwilling seller.” It doesn’t help that for many mortgage-backed investments, there isn’t much of a market to generate prices: Some of these securities simply are not widely traded and are not intended to be; in other cases, the markets have been attenuated to the extent that there are no willing buyers. Both of these conditions make the calculation of “market prices” an exercise in fuzziness.

Mark-to-market rules damage banks in two ways. The first is that banks have to treat losses on paper as though they were real economic losses, accepting fire-sale valuations of securities that they may not intend to sell. The second is that, because mark-to-market rules are used in assessing banks’ capital requirements, those paper losses can quickly become real losses when banks are forced to sell assets, often at an enormous loss, to raise enough capital to keep the regulators satisfied. Those pressured sales, in addition to locking in losses, tend to drive down the prices of similar assets, creating a vicious cycle of wealth destruction. The market becomes a snake swallowing its own tail.

Given the disputable nature of the “market prices” in question, it is far from clear that mark-to-market rules are giving investors and regulators the intended benefit. And while reforming mark-to-market will by no means provide a magic bullet to solve the deep trouble in the financial industry, it is clear that the practice is having a harmful effect on many banks and institutional holders of mortgage-backed assets, amplifying what would otherwise be more manageable problems and exacerbating the volatility in the markets. Which is to say, mark-to-market should be booked as a net loss on Washington’s balance sheet. That view has been voiced by the likes of Warren Buffett, Ben Bernanke, and Barney Frank — hardly a like-minded bunch.

HR1349, introduced by Democrat Ed Perlmutter and Republican Frank Lucas, would create a new Federal Accounting Oversight Board that would supplant the Securities and Exchange Commission and the Financial Accounting Standards Board as the government’s main accounting overlord. The new board would be charged with reviewing mark-to-market and other rules, and its policy portfolio would be broader, taking into account questions such as systemic risk and the need to treat liquid and illiquid assets differently. In the context of reforming our accounting practices more deeply, an intelligently executed loosening or suspension of mark-to-market rules is a prudent policy, and should be pursued

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