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October 5, 2008

What to do about mark to market accounting

There has been a lot of discussion in the press about mark to market accounting and what role it had on creating the financial situation we now find ourselves in. The SEC caught a lot of flack for revising their rules on mark to market accounting in response to this situation, and while I'm certainly not a securities expert in a position to comment on the whole thing, they've made some good points that haven't been properly appreciated.

Mark to market accounting has replaced hold to maturity accounting in most modern financial entities. Hold to maturity accounting was the older method, and in it you assumed in your company's financials that as long as the entity that owes you money continues to make their payments (the alternative is called impaired) that it was worth what you paid for it. Under mark to market accounting, the idea is that the price that you hold something on your books should be the price that the instrument is actually worth. When markets are well functioning, most experts agree that mark to market is a better system. This way when you hold an asset that loses value you gradually reduce its value rather than hold it at full value until it essentially worthless and then rapidly revalue it. This prevents management from deluding itself, shareholders, regulators, and creditors on the value of the firm's assets by forcing them to use available information of their assets. This may sound difficult, but as long as the assets in question are traded regularly in competitive markets it is easy. All you have to do is hold an asset on your books at the price that it is selling for. When that price goes up you raise the price you hold it at and when it goes down you lower it.

A problem happens when the asset is not regularly traded in competitive markets. Imagine a financial derivative that that for some reason has only a single market maker firm A. They sells one unit of this product to firm B for $100 and 1 unit to firm C for $100. At some point firm C runs into unrelated financial trouble. A and B both decide that they have the right amount of the product for their needs and don't want any. After much searching firm B finds that firm D will buy the product for $50. Grant Arguendo, that the economic fundamentals haven't changed enough to justify this massive price change, and that firm C's problems don't have anything to do with this asset. Say firm A has mark to market accounting. At what price should they hold their derivative? It would seem naive to hold it at $50. If the economic fundamentals haven't changed and firms A and B are unlikely to be in the same desperate straights that firm C found itself in then holding the assets at $50 each would underestimate the amount of money they owe to firm B and now firm D. Sometimes in illiquid markets the price can move away from fundamental value because there are not enough participants with the money to force the price of assets to be the most correct one. In that case using market prices is not optimal. Yes, always using an externally validated price is transparent but it need not be accurate or sensible as the example above shows.

Which brings us to what the SEC has clarified:

Can transactions in an inactive market affect fair value measurements?

Yes. A quoted market price in an active market for the identical asset is most representative of fair value and thus is required to be used (generally without adjustment). Transactions in inactive markets may be inputs when measuring fair value, but would likely not be determinative. If they are orderly, transactions should be considered in management's estimate of fair value. However, if prices in an inactive market do not reflect current prices for the same or similar assets, adjustments may be necessary to arrive at fair value.

A significant increase in the spread between the amount sellers are "asking" and the price that buyers are "bidding," or the presence of a relatively small number of "bidding" parties, are indicators that should be considered in determining whether a market is inactive. The determination of whether a market is active or not requires judgment.

I'm not saying that SEC wouldn't want to weaken mark to market accounting as a matter of political expediency. I surely know that allowing too much discretion outside of market pricing allows traders, portfolio managers and CFO to abuse the system. Yet if an independent observer would agree that markets are not functioning it seems silly to use their prices to mark your own assets. Especially when covenants in your loans might force you to liquidate as a result, making an accounting convention into real economic damage as you are forced to sell into a dysfunctional and frozen market.

Posted by OneEyedMan at October 5, 2008 2:19 PM

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