Financial Crisis: Mark to Market Accounting Demystified

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Of late there has been a lot of negative press around the accounting requirements for companies and the methods by which they have to value their assets. Some critics and company executives have even attributed the accounting requirements, and specifically the Mark to Market valuation method, as a major cause behind the rapid failure of some of our largest financial institutions, because they were forced to value assets at unrealistically low levels. The Securities and Exchange Commission (SEC) and Financial Accounting Standards Board (FASB) which sets accounting rules for companies, are being pressured by lawmakers, corporation and big investors to overhaul or suspend the current Mark to Market accounting rules that these companies have to follow. This type of accounting (like leverage), works great in boom times but can place a lot of pressure on companies and their stock prices when asset values fall. As an investor it is important to have a general understanding of how this type of accounting works in order to get a better of the state of the company’s real financial health (and so you know what those pundits on CNBC are talking about!). Here, Tony Parker assists in breaking down Mark to Market accounting in an easy to understand format with examples and why it is causing so many headaches for companies.

What is it?

The act of assigning a value to an asset based on it current market value (what it could sell for today) as determined by the going “market price”. For example, your house may have been worth $300,000 on 1/1/2007 but today according to the market it is worth $230,000. If you kept track of your assets like a company did, you would be required to “write-down” the value of your house by $70,000 to reflect the fact that if you had to immediately liquidate that asset (your house), it would not bring the kind of cash it would have about two years earlier.

Why was it implemented?

It was primarily intended to prevent shady accounting practices that hide underlying liabilities. The Accounting Standards bodies were concerned that companies were keeping “bad” assets on their books instead of “writing them down” to their real value (assigning a new, lower value to the asset). Mark to Market gives investors a much better “picture” of the health of the company if their assets are correctly priced (i.e. market price).

Example: Ford is holding 100,000 F-150 trucks on a storage lot. Ford originally valued these at $20,000 each. So, Ford books this as an asset with a value of $2,000,000 (100,000 x $20,000). But several months go by and Ford has not sold these trucks (high gas prices, economy, etc.). Now it is 6 months later and Ford must mark to market the value of those trucks for their quarterly reporting. Over the six months the true market value of trucks has dropped to $15,000 (based on what customers are currently paying). In this case, Ford should write-down the total value of the trucks to $1,500,000. This means Ford’s assets (the trucks) have fallen in value by $500,000.

So why is this important?

To keep it simple, the most basic thing in accounting is the equation: Assets – Liabilities = Equity or, in common terms, Assets (things owned) minus Liabilities (debt) = Equity (value of the company – reflected in the stock price). If you reduce the value of the assets, then the value of the company must drop, thereby pushing down the equity (stock price). So continuing with the example above, Ford’s share price will drop as the value of it’s assets (trucks) are marked down. So do you see now how the falls in assets prices can quickly translate to stock prices drops under mark to market accounting?

Why is it causing so much controversy?

The Mark to Market rule works well until you cannot get a realistic price for an asset. Currently, many of the Mortgage Backed Securities (a combination of many mortgages pulled together as one security) that are behind the financial crisis have NO market and hence almost impossible to assign a fair value (unlike those of Ford trucks). Because of their perceived risk and unknown exposure nobody wants them and in many cases if there is no demand they become worthless ($0 value). This obviously is NOT true. Even if the value is 5 cents on the dollar, they still have a value. But the securities are so complex and the economic environment so uncertain, that nobody is willing to “stick their neck out” and try to pick the correct price.

Here is an analogy: Say there is a unique subdivision with 100 gorgeous houses. If these houses were any place “normal” they would be worth $1,000,000 each. But this subdivision sits on top of an old graveyard. Now most people would never pay full price for a house sitting on top of a graveyard (the potential for ghosts and all!). But what is each house worth? Some people probably would not care much about the graveyard as long as they got $200,000 off the selling price. So, is $800,000 the Mark to Market price? On the other hand, some people would only buy one of the homes if it were substantially discounted, say to ¼ of the original price. So, is $250,000 the Mark to Market price?

Now lets add one more obstacle. Let’s say – as is currently happening – it is very, very difficult to get a loan (mortgage). There is then the potential that NOBODY would buy one of the homes, because they could not get a mortgage, even though they may have been able to get a big discount. One financial quarter (3 months) goes buy and none of the homes sell. What is the Mark to Market value of these homes now? Without any direct comparisons (after all, this is like no other subdivision), the Mark to Market value would be ZERO. We know that is not true, but if the accountants assign an arbitrary value, say $700,000, they may get in trouble if later they are required to write-down the value of those homes to $250,000 each, when they find out very few people are comfortable living on top of a graveyard. So the problem is: What value should you assign to an asset that has no current market (no buyers)? By the letter of law you value them at current value – zero in this example – but as you can see that is hardly fair.

This is essentially the problem currently choking financial markets with MBS and other housing based instruments. Critics of the Mark to Market accounting rules say that they cause banks to undervalue assets that have a real value based on fire-sale prices in a frozen market.

“A vast majority of mortgages, corporate bonds, and structured debts are still performing. But because the market is frozen, the prices of these assets have fallen below their true value. Firms that are otherwise solvent must price assets to fire-sale values. Not only does this make them ripe for forced liquidation, but it chases away capital and leads to a further decline in asset values,” wrote Brian Wesbury in the WSJ.

Conclusion and Opinions

Tony –
My personal recommendation is to keep the Market to Mark rule, but in cases where you cannot come up with a reasonable value – because of usual economic forces or a sufficiently liquid market – then guess conservatively and highlight the item to investors in t
he financial statements, so they can determine whether the value assigned is reasonable to them.

Andy – One point to note is that even if Mark-to-Market rules were suspended, it won’t change the makeup of a company’s balance sheet. If investors decide certain company’s assets are toxic (like MBS nowadays) then it won’t matter how a company accounts for them in its books – they will be assigned a zero or negative value by default. To get out of the current financial crisis, investors need to have confidence in the financial assets/instruments of these companies. That is what the government is trying to primarily do with the bailout bill – restore investor confidence by buying and creating a fair market value for these “bad” and illiquid assets. However, judging by recent market action it doesn’t look to be working too well.

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