Sunday, February 22, 2009

Why mark-to-market accounting is flawed

Mark-to-market accounting is at the heart of the current financial crisis. Some banks are currently in financial trouble based on mark-to-market accounting, but not based on traditional accrual accounting.

Worthwhile Canadian Initiative explains how mark-to-market accounting is flawed:
The wisdom of MTM [mark to market] accounting has been debated before and since its original implementation. On the one hand, it “shines a light” on developing asset value problems. On the other, it has the potential to exaggerate volatility in reported earnings, in some cases unnecessarily. As a simple example, a 5 year fixed rate loan or bond that matures in tact may exhibit substantial MTM volatility throughout its lifetime. But such volatility accumulates to zero net effect by the time the bond matures. ...

A relevant and connected analogy exists in the household sector. The housing boom was based on easy credit and an implied belief in MTM accounting for houses, otherwise known as the ATM effect. Current house prices, however inflated, were the basis for many hundreds of billions of dollars of mortgage equity withdrawals (MEW). Those who bet on housing MTM as an indicator of sustainable price appreciation behaved accordingly. So did mortgage lenders. Those who restrained from using MTM as a mental accounting of a sustained trajectory of personal wealth, and who considered such MTM information with more restraint, probably checked their behaviour more wisely in terms of allowing for risk. In order words, behaviour was a function of how households viewed the effect of housing MTM on their personal balance sheets and longer term capital positions. Those who resisted incorporating full MTM into their own capital evaluations were probably more restrained in MEW transactions and related spending. Those who acted aggressively on their housing MTM profile overextended their balance sheets and spent the money from their MEW proceeds.
If mark-to-market accounting can overstate an asset's value during a bubble, it can understate its value during a panic. For international banks, which have some or all of their assets subject to mark-to-market accounting, the difference between accrual accounting and mark-to-market accounting can be the difference between solvency and insolvency.


  1. Mark to market is what we've NEEDED for so long! How can a bond be "worth" a set rate, if nobody will pay that amount for it?

  2. Financial problems generally occur when there is forced liquidation....forclosures have historically occurred when there was divorce, job loss, sickness, etc. A bank forced to take back a house was forced to deal with what the house was worth AT THAT MOMENT. If you have to sell stocks today to fund retirement then you are forced to take what someone will pay for them TODAY! Ignoring the fluctuations in market prices is absurd when considering the downside. Failing to account for the downside is what kills people. It's like a huge margin call. Everyone should know that investing on margin is dangerous precisely because of the potential short term downside mark to market. Ignoring upside swings to remain conservative is entirely different. Ignoring the valuations during bubbles would only mean a loss of opportunity costs, not actual losses, much like a retiree moving to cash, yes they may miss the upside, but it's the downside that will kill them. Everyone knows that losing real money is entirely different than realizing opportunity costs.

    Marking to Market is realty. Reality is usually only painful on the downside. Insisting on Marking to Market is choosing security over potential growth/profit.

    It is healthy in the long term to stick with Mark to Market.

    Average Joe

  3. It is noteworthy that mark-to-market is questioned and criticized by the financial services industry when values decline - never when their asset prices are inflating and being used to curry favor with investors or as collateral for borrowing more or to purchase additional assets. But then again, consistency and principles are in short supply amongst banks and their apologists.

  4. Mark to market accounting isn't killing these banks, it's bad loans.

  5. not so sure if this will be an effective way to pay for our debt?

  6. the big question is...does it really help???

    - ledz -

  7. I'm not saying that accrual accounting is better. I'm just saying that it's less volatile. When there is a decline in the intrinsic value of an asset, accrual accounting will be slower to recognize the decline, which is bad. On the other hand, accrual accounting is less likely to overshoot (in both directions), which is good. Since all banks are highly leveraged (compared to non-financial companies), overshooting can be a killer.

    If a bank issues a bunch of loans, and keeps the loans on its own books, the bank MUST use accrual accounting, because mark-to-market accounting is impossible for non-traded assets. On the other hand, if a bank sells those loans to another bank as mortgage-backed securities, the other bank may be required to value them using mark-to-market accounting. The long-term value of the underlying loans is exactly the same, but the accounting method varies depending on whether the loans are simply kept on the original bank's books or sold off as securities.

    Also, remember what the blog post pointed out. The people who were fooled by the housing bubble were the people who believed in the mark-to-market value of houses. The people who were not fooled were the people who essentially used accrual accounting, by comparing the prices of homes to the rents they could generate.

  8. Dupontguy said...
    "It is noteworthy that mark-to-market is questioned and criticized by the financial services industry when values decline - never when their asset prices are inflating..."

    Very true. The absolute worst accounting method is to switch back and forth between accounting methods depending on what makes the assets look best.

  9. marking to market is transparent, the opposite of opaque. opacity is a confidence killer.

  10. guy n. cognito said...
    "marking to market is transparent, the opposite of opaque. opacity is a confidence killer."

    The original post, but not the part I quoted, addressed this issue:

    "The first fallacy is that MTM accounting is necessary in order to produce balance sheet transparency. This is not the case. Given the nature of the information it conveys, we can say more accurately that MTM accounting is a sufficient, but not a necessary condition for transparency. Insofar as asset values are concerned, the necessary condition is MTM disclosure, not MTM accounting. Exactly the same information can be made public through disclosure, without necessarily affecting reported earnings and capital positions."

  11. from the post... "Exactly the same information can be made public through disclosure, without necessarily affecting reported earnings and capital positions."

    so you tell everyone you're getting killed and losing your shirt, but you don't reflect that in the numbers? how could an auditor verify your on-going condition when your public statements are to the contrary?

  12. None of you understand this issue, so don't bother commenting on it.

  13. Mark to Market is a stupid idea in this current credit freeze why?

    It is based on a theory that there's always a ready market for
    nearly every asset, including financial assets. Now, in times like this, when there is a sudden freezing of credit markets, it's become clear that there isn't always a liquid market. So marking to market becomes impossible.