Relaxing Mark To Market

This is bad:

“A once-obscure accounting rule that infuriated banks, who blamed it for worsening the financial crisis, was changed Thursday to give banks more discretion in reporting the value of mortgage securities.

The change seems likely to allow banks to report higher profits by assuming that the securities are worth more than anyone is now willing to pay for them. But critics objected that the change could further damage the credibility of financial institutions by enabling them to avoid recognizing losses from bad loans they have made.

Critics also said that since the rules were changed under heavy political pressure, the move compromised the independence of the organization that did it, the Financial Accounting Standards Board.

During the financial crisis, the market prices of many securities, particularly those backed by subprime home mortgages, have plunged to fractions of their original prices. That has forced banks to report hundreds of billions of dollars in losses over the last year, because some of those securities must be reported at market value each three months, with the bank showing a profit or loss based on the change.

Bankers bitterly complained that the current market prices were the result of distressed sales and that they should be allowed to ignore those prices and value the securities instead at their value in a normal market. At first FASB, pronounced FAS-bee, resisted making changes, but that changed within a few days of a Congressional hearing at which legislators from both parties demanded the board act.

“There is a perception that we are yielding to political pressure,” one board member, Lawrence W. Smith, said as he voted for the changes.

“We are an independent standard setter, and it is important that we maintain our independence,” Mr. Smith added. “At the same time, how can we ignore what is going on around us?””

You maintain your independence by refusing to act against your better judgment in the face of political pressure, that’s how. If you have to ask how you can ignore that pressure, then you forfeit the right to claim independence. The members of the Committee who “demanded the board act” should be ashamed: whatever you think of the FASB’s new rules, they ought not to pressure a supposedly independent agency. (I don’t know who they are; the transcript of that meeting isn’t up yet.)

Mark-to-market is a way of deciding how much a firm’s assets are worth. Basically, it requires that you record (‘mark’) the value of an asset to its market price: the price at which it, or things like it, is currently trading. (There are exceptions, e.g. for assets you do plan to hold to maturity rather than to sell.) This works well if you are trying to value one of a large number of basically interchangeable goods that trade frequently: a box of Cheerios, say, or a share of IBM. It works pretty well with goods that are more or less comparable to other goods that trade reasonably frequently. (Think of houses.) It works much less well for things that are unique or hard to compare to other things, and/or that trade only rarely. (Imagine trying to value a Picasso in a world in which paintings changed hands only once a year. Last year a Byzantine icon sold; the year before that, a Fragonard; the year before that, one of Julian Schnabel’s plate paintings: how on earth do you value your Georgia O’Keeffe?)

Besides that, mark-to-market accounting tends to be, as they say, procyclical: when there are bubbles, mark-to-market accounting will show inflated values for things; when everyone is selling at fire-sale prices, a company’s assets can suddenly plummet in value. (Enron was an early adopter of mark-to-market, and benefitted a lot from its tendency to overstate the value of assets during bubbles.)

That said, what’s the alternative? In the case of assets that a company plans to hold to maturity, rather than to sell, you can value the asset based on the income it will bring in over time, given your best estimate of default rates. But in the case of an asset that you plan to sell at some point, it’s hard to see what, other than the market price, a company should use to value its assets. Generally, companies develop models to come up with valuations; this approach (‘mark to model’) is sometimes referred to as ‘mark to myth’, for obvious reasons.

Mark to model is, however, the best way to value an asset in some cases, like my painting example above. It’s hard to mark to market when there is no market. But when, exactly, is there so little decent market data that you have to use mark to model? What FASB has done, if I understand it, is to allow companies to use mark to model in more cases than they could have done before. Willem Buiter:

“Up till now, a frequent source of level 2 information were prices achieved by competitors’ asset sales to help determine the fair-market value of similar securities they hold on their own books. Banks are now allowed to ignore prices achieved in competitors’ asset sales when these transactions that aren’t “orderly”. This includes transactions in which the seller is near bankruptcy or needed to sell the asset to comply with regulatory requirements. This is vague and broad enough to drive a coach and horses through fair-value accounting for most imperfectly liquid assets.”

We are trying to get banks to write down their toxic assets. The longer this takes, the longer the financial industry will be crippled by uncertainty about what lurking horrors are concealed in banks’ balance sheets. This rule really, really does not help.

If marking banks’ assets to their market value would produce some unacceptable consequence, the answer is not to let them conceal those values. Noting the value of an asset is just a way of providing information. That information doesn’t produce any effects all by itself. If regulators respond to drops in the value of firms’ assets in what we think is a bad way, the right response is to change our regulations, not to let banks fudge their assets’ values. And if other market participants do things we don’t like when banks’ assets drop, that is surely their right.