Mark-to-Market – Keeping the Banks Honest

First off, let me say that mark-to-market did not cause the economic crisis despite what some bank CEOs may tell you. A series of risky investments and lending money to borrowers with no prospect of ever repaying their loans brought us to our present situation. So with that cleared up, let’s look at some of the discussion around current bank valuations and the question of mark-to-market accounting.

Mark-to-market – also known as the fair value rule – is an accounting regulation that requires companies to assign a value to both their assets and their debts each quarter based on current market prices. This rule was implemented to ensure that companies provide a true representation of their financial standing so that regulators and investors can accurately determine the viability and profitability of each publically-traded company. While the goal of this rule is to eliminate “creative accounting”, the concept of mark-to-market has been exploited in the past, perhaps most famously by Enron.

Enron specialized in energy futures and created a series of new securities including long-term gas futures contracts which often traded without a quoted market price. This permitted Enron to develop their own “discretionary” pricing model for derivatives to arrive at marked-to-market pricing. Given such wide latitude to set their own market prices, and knowing what we do now about the Enron culture, it is hardly surprising that these prices were a bit inflated – more like mark-to-make believe really – and this allowed Enron to show a series of massive profits. Naturally, these artificial prices could only be sustained for so long before crashing, which Enron did in spectacular fashion. This is why it is somewhat alarming to hear bank execs and even some politicians suggesting that the mark-to-market should be abandoned to “help revive” the banking system.

The banks claim that the mark-to-market rule will force them to report massive losses on their balance sheets for assets that have lost most of their value, but which the banks have no intention to sell at this time. They feel that these “paper losses” should not be counted against them until the assets are actually sold. Apparently, the banks still believe that all these aptly-named toxic assets will someday regain their value, at which point investors will be lined-up to buy and everything will return to normal again.

Right – as appealing as this delusional bit of thinking may be to the banks, millions of private investors have seen these “paper losses” tear their own portfolios to shreds so I’m thinking there is not a lot of support for the banks on this question right now. However, on one front, an argument could be made for easing the fair market rules – for the time being at least. Now don’t read this as me being soft on the banks – for reporting purposes as described above, I say fair value all the way, but for regulatory purposes, perhaps we should examine the question more closely.

That’s because, when providing valuations for disclosure or reporting, no additional action is required on the part of investors or the public in general, but for regulatory assessments, the losses could have important implications. If banks marked assets to market prices when determining capitalization levels, there is little doubt that the losses would cause many of the large banks to fall short of the minimum regulated targets. These banks would then be forced to find investors willing to provide enough capital to bring their reserve funds up to acceptable levels, but given the lack of credit within the system – matched only by the lack of trust the banks have for each other right now – it seems likely that the taxpayer would ultimately have to provide the funds.

Secondly, doing away with capitalization level requirements could actually lend more credibility to the ongoing bank stress tests – which quite frankly, are already suffering from a credibility shortfall. The purpose of the stress tests is to determine how much capital each of the major banks needs to remain solvent should the economy follow the scenario predicted by the Treasury Department – could this not serve as the regulatory check on bank solvency? Make the banks complete their quarterly report using mark-to-market accounting to ensure full transparency and disclosure but use the findings of the stress test to confirm capitalization needs.

The Financial Account Standards Board (FASB) – the private sector organization responsible for establishing US accounting standards – has scheduled a vote on April 2nd to look at the possibility of easing mark-to-market requirements. No doubt, the banks would like to see fair value suspended across the board for both reporting and capitalization assessments, but this seems unwarranted with the stress tests due for the end of April. It is not yet clear which way the FASB is leaning, but the idea of the status quo for reporting, while easing the regulatory side of the issue, may be worthy of consideration.