"But somewhere in there is a legitimate, rational debate."

Accrued Interest addresses Mark-To-Market:

"Mark-to-market accounting has got to be one of the most controversial topics of the year. Unfortunately, its also rife with bias and downright zealotry. You have on one side apologists for financial companies and/or people looking for a one-trick excuse for the whole financial meltdown. On the other hand, you have people who believe all of Wall Street is just lying and everything they own is worthless.


But somewhere in there is a legitimate, rational debate. ( TRUE )


First let's consider what accounting is supposed to achieve. Broadly speaking, accounting should have a few simple goals:


1) Accurately reflect the current economic situation of a firm.

2) Allow for comparison of a firm's results and position over time.

3) Allow for comparison of one firm to another.

4) Be as objective as possible.

( IT'S A GOOD LIST, BUT I WOULD INCLUDE THE NOTION OF SOCIAL CONFIDENCE. IN OTHER WORDS, A SYSTEM OF ACCOUNTING THAT THE PUBLIC CAN TRUST AND BELIEVE IN, EVEN IF NOT INVOLVED IN THIS ISSUE PERSONALLY IN ANY WAY. IT COULD BE THAT MARK-TO- MARKET INSTILLS MORE CONFIDENCE IN THE SYSTEM )

Now let's consider how mark-to-market as a concept fits in with these goals. I call mark-to-market a "Liquidation Theory of Accounting." In other words, by marking all assets to where they could be sold, one is valuing a firm based on what it might be worth in liquidation( SELLING ).


This is clearly appropriate with any pool of assets intended to be traded in the open market( THAT NEED TO BE CONTINUALLY PRICED ). But in other assets, it isn't obvious that mark-to-market serves the 4 basic goals above. Take a life insurance company which bought the longest available Treasury Strip (5/15/2038) on August 8, when it was first trading. The position is an offset to their long-term liabilities, say the life insurance policy of a young person. For the sake of argument (and brevity) let's assume that the actuarial life of the policy holder is exactly 30-years, and the accrued interest on the strip will exactly cover the life policy with a small profit.


The strip was trading at $25.6 on 8/8, but is now about $42.5, an handsome 66% return( DUE TO CHANGES IN INTEREST RATES ).


But has the life company's economic situation changed? Is that firm 66% better off? We'd all agree that no, it isn't( THEY AREN'T GOING TO SELL IT. THEY MERELY KEEP GETTING THE SAME INTEREST AS BEFORE ). The basic economics of the firm haven't changed at all. They have the same liabilities and same cash flow stream. If we followed strict mark-to-market theory, we'd mark both the asset and the liability higher( BECAUSE THE STRIP IS WORTH MORE ), leaving the firm's balance sheet unchanged( SAME REVENUES ).


Or would we? Under current market conditions, "selling" the life insurance policy liability to another firm might be possible, but it would be highly unlikely to have the same gain as the Treasury position( IT WILL SELL FOR LESS ).


That example is very black and white, and of course, the real world is much more grey. Its easy to use a Treasury bond as an example, where we know the change in market value isn't reflective of a change in asset quality. But where there has been a real change in asset quality, the situation becomes more grey.


But still, mark-to-market still doesn't fully satisfy. Let's say that we have two firms, both have made loans to XYZ Retailer. But one is a bank which has made a traditional loan, and the other is a brokerage which holds a private placement bond. The broker almost certainly has to mark that loan to market, but the bank may not.


And in both cases, the rapid changing liquidity premium in the market place alters the "mark" for this asset. By this I mean, say the retailer is performing reasonably well, and thus the risk of non-payment remains remote. Given the weak economy, its obvious that the risk has increased by some degree, but given the extremely weak liquidity across fixed income products, the larger portion of the assets price decline would reflect liquidity( IT'S BECOME HARDER TO SELL, SO WORTH LESS. BUT THIS POINT CAN ALSO BE USED FOR FAIR VALUE, SINCE, IF THE BUSINESSES ARE HOLDING THESE ASSETS FOR THE LONG TERM, THERE IS A GOOD CHANCE THAT THEY WILL GO UP IN VALUE OVER TIME, AND SO VALUING THEM BASED UPON TODAY'S MARKET PRICE ISN'T FAIR, ESPECIALLY IF IT LEADS TO HIGHER CAPITAL REQUIREMENTS THAT FORCE THE BUSINESS TO SELL SOME OF ITS ASSETS AT A DISCOUNTED PRICE ). If the firms don't intend to trade the loan, is the changing liquidity premium relevant( NOT REALLY )?


There are other problems. Say you are a bank that has a private loan to a company with traded CDS contracts. Your best mark-to-market estimate would be to price the loan based on the cost of hedging out the credit risk. But in many cases, the CDS and cash bond markets have decoupled. Many bonds are trading a drastically wider levels than the CDS market, owing in part to easier funding of CDS. Take Amgen, where cash bonds are trading at a LIBOR spread of nearly 300bps, but the CDS are around 90bps. On a 10-year loan, that implies a valuation differential of about 15 points!( GOOD POINT )

So here again, we have a situation where two firms can use "market" prices to price non-marketable assets, and come up with wildly different valuations. We hear mark-to-market and assume that the "market" is some kind of observable thing. But that is just not the case( TRUE. IT DEPENDS ON WHAT THE METHOD IS USED FOR ).

I argue that when the current fair value accounting standards were cooked up, a rapid change in liquidity premia was never envisioned( THE MARKET WOULDN'T MOVE MUCH ). It was assumed that the market would deliver an efficient price which was primarily reflective of the real economic risks of a security. Thus a change in price would reflect a change in risks. It makes perfect sense in theory, but clearly does not reflect economic reality for some firms, nor does is it creating balance sheets which are comparable across firms( THE LAST FACT IS IMPORTANT ).


But what's the alternative? Those that are calling for an end to mark-to-market are out of their mind. First of all, there is no clear alternative. Second, we have enough trouble trusting firms' balance sheets as it is. Imagine if mark-to-market were suddenly suspended! ( IT WON'T PASS MUSTER, ESPECIALLY IN A CLIMATE OF DISTRUST )

And it doesn't help that so many critics of mark-to-market in the recent past have been managers of firms who were, in fact, fudging the real economic position of their firm( THAT'S THE BOTTOM LINE ).

So I don't know what the answer is. And I don't blame accounting for the financial crisis that we're going through. But I'd like to see some better ideas."

My idea is to have both accounting procedures done, if warranted, with Mark-To-Market the necessary one. In a financial crisis of any kind, a business could apply for an exemption from Mark-To-Market for a time based upon Fair Value Standards. However, the Mark-To-Market must be available as well in order to feel satisfied that everything looks in order. I don't know how this could be done, but the problem doesn't seem unsolvable.