Mark To What Market?

The debate over mark-to-market accounting – arcane and tedious though it sounds – has become relevant and (relatively) invigorating. The regulatory implications loom large over Treasury and the entire financial services industry.

Warren Buffett and Ben Stein, among others, have commented on the need to eliminate the practice; the “stress tests” that Secretary Geithner is conducting at the Department of the Treasury have implications that depend on the regulatory outcome.

Simply defined, mark-to-market accounting is the practice of recording assets at their “fair market value” on a company’s books. The practice often exists for marketable securities that trade on exchanges – and not, say, property or equipment that may fluctuate in “market” value without fluctuating in book value. More illiquid assets, like property and equipment, are recorded at cost and depreciated in typical accrual accounting fashion.

Enron notoriously marked assets UP to a market value based on financial valuation models that it controlled. Some of what’s happening now is a marking DOWN based on values that nobody knows.

The financial crisis has created an interesting problem for bank assets: many mortgage backed securities (MBS) and other illiquid (and now famously “toxic”) assets are nearly impossible to mark. There isn’t really a market on which they are trading. It’s a game of pin the tail on the donkey in which there isn’t a donkey in the same room as the helpless blindfolded pin-holder.

Warren Buffett mentioned the problem’s curious manifestations in his annual letter. Derivative contracts that Berkshire wrote to insure bonds had to be marked to market and incurred hundreds of millions of dollars in write-downs. Those same insurance policies within BHAC (Berkshire Hathaway Assurance Co.) are recorded under normal insurance company accrual accounting and result in nominal profits.

At issue now are regulatory mandates that force banks to write-down their assets and then require expensive and perversely-incented action to achieve capital requirements. Buffett lamented the impact of the practice on the financial crisis, calling it “gasoline on the fire.”

One distinction that begins to surface is important:

• Marking-to-market for reporting and disclosure purposes (when a company discloses the value of its traded assets) creates transparency and informs investors.
• Marking-to-market when a regulatory constraint follows can have serious, negative consequences and make toxic assets infect entire balance sheets.

A false choice exists between “abandoning” mark-to-market completely and keeping it with all its implications. Like all healthy regulation, the goal should be transparency.