Explain the controversy about mark-to-market accounting.

The Dave Ramsey, Brian Wesbury, and Newt Gingrich plans for economic-crisis relief each involved repealing the mark-to-market provision of the Sarbanes-Oxley Act.

Steve Forbes, on CNN, just suggested that marking to market “artificially lowers” the numbers on a company’s balance sheet.

Can someone explain why this is a popular measure, and how marking to market is an artificial hit?

Be gentle. I have no accounting background.

For background, check out Wikipedia on mark-to-market accounting.

I may be off base, but it seems their resistance is due to the fact that having to value a particular asset at a time when volatility in the market or other factors has driven the price of an asset artificially low is an inaccurate representation of the asset’s value. This can make the periodic financial statements of the company look worse than they should.

I suppose the converse would also be true, that in “bubble” situations the value of the asset would be overstated, making the company’s financial statements look better. I’m not an accountant, so I’m not sure what type of valuation was used before mark-to-market, but I would think placing a value at a particular point in time on certain types of assets would be problematic no matter what valuation method you used.

One alternative to mark to market in the past was acquisition price. You can see why that would leave an asset overvalued when, say, the asset is a CMO for which the market has now evaporated.

Another technique is when the company just makes a ballpark estimate of what a particularly exotic or illiquid asset is worth. What is the market value, for instance, of the future revenue stream from Rod Stewart’s publishing royalties (something a hedge fund might well have bought)?

Those arguing against mark to market use my second example – there is no ready market, but the asset is clearly worth something, and our number is the best estimate of what that something is.

Those arguing for mark to market look to my first example – if the market won’t pay anything for CMOs, maybe it’s because they’re worthless and we should value them as such.

Let’s step back for a moment and understand what the investments they are talking about actually are. The instruments are called collateralized debt obligations (CDOs), and they are similar to bonds. What people did was take a bunch of different mortgages, pool them together, and then slice them up into small pieces to sell. In other words, they would take 1000 mortgages, combine them all together, and then slice that up into 10,000 pieces to sell. If I buy one of these CDOs, I then own 1/10,000 of 1000 different mortgages.

Now, the question is how should I value this asset on my books. I can look at all 1000 mortgages and calculate my expected rate of return based on interest rates and expected defaults. On the other hand, you can look at the market to see what the other 9,999 CDOs that came off of the same 1000 mortgages are selling for. In other words, if the exact same CDO I hold just sold for $100, I change my books to value my CDO at $100. This is what they mean by mark to market, and it’s currently a requirement for companies.

Why people think this is a problem is a concept called margin calls. If I am an investment company, I don’t just take peoples investments and buy stuff with them. I use those investments as collateral and take a loan. Basically, if I get X dollars of investments, I put those X dollars up as collateral, and get a loan for 3X. I then invest the 4X (3X loan + X original investment) in order to get better results on my bets. For example, if my bets result in the investment going up 1%, I would return a 4%, minus some interest on my loans, increase in value to my investments.

Now we get to the margin call part. The investment companies put up their investments as collateral. If these investments decline in value, the people giving out the loans are going to want to see some cash put up as collateral to make up for the declining value of the collateral. Basically, if my investments go down 5%, the people giving me the loans are going to come to me and say put $5 million down on the table. It’s not just the creditors though. The Govt. also has their legal limits on how much you can borrow as an investment company. Normally companies have enough excess cash to plunk down, but if the value of their investments decline far enough, they will have to sell some to come up with the cash.

Ok, now we get back to why people want to suspend this mark to market rule. Imagine that you hold these CDOs. You have your internal value calculations based on the expected default rates and interest rates on the underlying mortgage. Let’s say that it’s $1. However, you are required to value your CDO based on the market price as a basis for the value of the collateral. Let’s say that it is 75 cents right now. You have enough cash on hand to cover the margins on your loans, and obviously if you think something is worth $1, you aren’t going to sell it for 75 cents. But what happens if the price drops to 50 cents?

Nothing has changed in your internal valuation of the CDO. It’s still worth $1 in your mind, so you won’t sell at 50 cents. However, now that the mark to market value is 50 cents your creditors are coming to get you to put some cash on the table. If you look at your books and say “Oh shit, not enough free cash”, you are forced to sell some CDOs to make the margin call. In other words, you are legally forced to sell something at half of what you think its value is. Usually its just too bad, so sad for the company, but the problem is what happens to the value of those CDOs. Now that I sold to the guy willing to pay 50 cents, the next buyer might only be willing to pay 45 cents. Then, the mark to market has to be 45 cents which might trigger a margin call on another company. Then that company sells, and depresses the price to 40 cents, and so on until the CDOs are basically worthless and a ton of investment firms have gone tits up.

Everything Tries says is accurate. However, the suspending the MtoM rule is like shooting the messenger. The problem is that a load of companies bought dodgy CDOs. All the MtoM method exposed was that these companies are in trouble -which is true no matter how you account for it. It is the underlying asset that is the problem, not the accounting.

oh and while the MtoM method may trigger a wave of selling and further asset devaluation, the problem is then the rigid rules that enforce the selling.

Exactly: each rule has downsides. We just need to ask which one we’re more scared of.

An acquisition price rule (book value=what you paid for it) means that if an asset is overvalued when you buy it, it’s overvalued on your books. So under that rule, it may look like a company’s not in trouble when it is.

A MTM rule, as amazingly described above, risks the opposite problem: that things that are “really” worth $1 appear on your books at $0.50. So your company looks like it’s not in trouble when it is.

As a little background, the gov’t bailout has sought to buy up these CDOs so that the companies don’t have to dump them at firesale prices. The CDOs aren’t necessarily “dodgy”…they may pay out eventually. The reason they’re “bad”, “poinsonous”, or “toxic”, as the media has labelled them, is because they can’t be sold because no one wants them. It’s a confidence issue, really. There’s good CDOs that will pay out and bad ones that won’t. If I can’t tell them apart, I’m not touching the things. The gov’t, however, can.

True - also the CDOs are not ‘toxic’ to the institutions that own them, they are more like Schroedinger’s cat - there might be something of value in the box, or the box might be empty.

However they are ‘toxic’ to the institutions that ‘guaranteed’/‘insured’ the CDOs, and IIRC AIG was big in that game - which suggests to me that it is the current owner of AIG that really needs to worry.

For the US Govt, buying up CDOs might not be so dumb.

I thought this post by Megan McArdle, was very good.

Thanks, everyone. I wasn’t sure what the alternatives to mark-to-market were, and it seemed counterintuitive to me that valuing something at a price other than its current market price would be more accurate.

It’s very common in finance and accounting, because temporary, current market value is often unrelated to long term performance. A company would have to spend all its time revaluing stuff if it had to report everything at market value, all the time every time. And these issues are grotesquely huger in international business, which gets into cross-market pricing and exchange fluctuations.