Mark to Market

There have been many words, most of them ill informed, written regarding the amendments to FAS157 which have allowed financial institutions to carry their assets at “fair value” i.e. a mark to model price.

Before the amendments were made in 2009 things seemed to work quite nicely, from an accounting perspective at least. An asset would be initially held at cost and would remain there until there was either a transaction at a different value or there was clear evidence of impairment or an increase in value. Due to the accounting principle of prudence, there would be a higher burden of proof for marking up than for marking down. This may have meant that there was a little too much scope for downward earnings manipulation but as far as I am aware no financial system ever collapsed due to overly conservative accounting.

I do not subscribe to the view that mark to market accounting was a cause of the financial crisis. Once the decline in asset values began there was undoubtedly a negative feedback effect of writedowns forcing further sales. However I strongly maintain that the problem was under-capitalisation, not mark to market. If an institution is too highly leveraged to hold the asset to maturity then what possible justification is there for not marking to a tradeable exit price.

The answer of course is that in order to maintain the illusion of solvency in the zombie banks, the FASB caved and allowed objective evidence of value to be replaced by model based mark to fantasy. I have no problem with this approach if accompanied by stringent capital requirements for assets not marked at current trade levels but there has been no linkage established between accounting treatment and capital. Quite the opposite in fact – these marked to fantasy assets increase the optical solvency of the institution and potentially decrease the required capital held.

It gets even worse. In my day job I deal with a number of auditors, rating agencies and independent valuation agencies. Far from being watchdogs, they have become cheerleaders for this new “fair value”, forcing financial institutions to write up illiquid assets which are unlikely to be held to maturity to values where there are no willing buyers in anything like the sizes required. As their “analysis” is often based on “comparative asset values” and they are against liquidity discounts (too subjective!!!!!!) this is causing a spiral in the paper valuation of assets, with no liquid market transactions to back them up. Does this sound familiar?

We appear to have come full circle from the purpose of FAS157 which was amended after Enron’s mark to market excesses to make sure that assets reflected their exit price. What is certain is that the assets of the big banks, in aggregate if not on a case by case basis, are wildly in excess of their exit prices. Let’s hope that they are sufficiently capitalized to see this through or 2008 will look like a walk in the park.