Monday, April 13, 2009

no exact measures of the illiquidity discount or of expected losses based on fundamentals

TO BE NOTED: From Crisis Talk:

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The Great Mark-to-Market Debate

The leaders of the Group of 20 (G20) recently called on the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) to improve financial reporting standards for calculating the market value of assets in illiquid markets. The debate over mark-to-market accounting, which is a subset of fair-value accounting, and its role in the financial crisis, made its way to Congress during the first half of March 2009. The concern is that banks will not incur the losses booked per mark-to-market accounting as asset values recover over time from today’s clearance sale prices.

The mark-to-market concept may sound trivial, especially when compared to a $787 billion rescue plan, but getting it right would be a significant step toward addressing the causes of the credit crisis. The main aim is to simplify the complexity of financial reporting and off-balance sheet financing and to make progress towards a single set of high quality global accounting standards.

In a forthcoming paper in the Journal of Economic Policy Reform, I discuss the costs of mark-to-market valuation within the US 2009 (Bailout) Emergency Economic Stabilization Act (EESA). The paper highlights how mark-to-market valuation standards influenced financial institutions, explains why mark-to-market policy suspension proponents can support EESA, and explains how the FASB and the SEC can count on EESA while assessing the need for mark-to-market valuation policy.

Briefly, these are the ways in which mark-to-market accounting standards have influenced financial institutions:

  1. It led them to revalue assets they held to their market value on the day that the reporting period ended.
  2. Mark-to-market accounting standards introduced more volatility to the balance sheets of firms.
  3. The devaluation that resulted from the markdown of mortgage-backed securities has forced highly-leveraged financial firms to ask for new capital or put liquid assets on sale to bring their leverage down.
  4. The problem with mark-to-market comes when assets are not easily measured.
  5. The losses are likely to harm bondholders less than stockholders because banks may need to raise capital by selling shares.
  6. Illiquidity leads expected losses based on credit fundamentals to divert substantially from “mark-to-market” losses. The liquidity premium is the key difference given that there are no exact measures of the illiquidity discount or of expected losses based on fundamentals.
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