Sunday, March 15, 2009

Is Mark-to-Market a Good or a Bad Rule?

For those of you who aren’t familiar with mark to market, the term refers to the present day value of an investment, regardless of how much was originally invested. It was put in place as a part of US GAAP in the early 1990s, and the use has increased steadily over the past decade, primarily in response to investor demand for relevant and timely financial statements that will aid in making better informed decisions (according to Wikipedia J).

A good example of mark-to-market is people’s homes. Let’s say you bought your 2 bedroom apartment in Miami Beach for $300k two years ago. Taking into account the current real estate market, if you were to mark-to-market the current value of the apartment it would probably be closer to $200k.

Companies like GE, Citigroup, Bank of America, Wells Fargo, and many other financial institutions would benefit greatly if mark to market accounting were suspended.

The largest example is probably AIG. Currently, AIG is a $1b company, give or take. The stock is teetering at around 50 cents! Compare that to Bank Hapoalim – Israel’s largest bank – which has a $2.2b market cap – with a tenth of the assets! AIG became insolvent and was subsequently bailed out by the US TARP, due to mark-to-market accounting standards. Without mark-to-market, it would have survived. But would this been a good thing, or a perpetuation of the financial facade?

But more importantly – to save the global economy - the question is would suspending mark-to-market be a good idea or a bad idea to stimulate or save the economic meltdown? Two options:

1) Bad: Suspending mark-to-market accounting could completely destroy the financial system, since banks would be able restore assets to their original value and investors would have a much tougher time understanding the true value of these companies.
2) Good: On the other hand, on paper the banks would look more attractive and the investment dollars would return to these institutions. Subsequently, lending / borrowing would be restored quickly, and perhaps the underlying values would slowly catch up to the paper value.

I am not an economist, so thoughts?

1 comment:

  1. 3 points. 1) your example of an apartment in miami beach is not 100% accurate. A bond that AIG or a bank holds on their books has cash flow (monthly or quarterly) so just because right now we find ourselves in an unusual environment and the value of that particular bond is extremely low (because their are no buyers) does not reflect the true value of that bond. So to mark it to 20 cents on the dollar, or wherever he last trade was does not make sense (even though that is what MTM requires) 2) mark to market was not the only thing that pushed AIG to the brink. AIG was massively undercapitalized for the amount of risk they were taking and it finally caught up to them. Their CDS portfolio especially. (basically writting insurance with little or no reserves set aside) Their thin capital led to rating agency downgrades which then led to AIG being required to post a lot more collateral. 3) Your 2 alternatives - or opinions on MTM are too limiting. I think you can find a middle ground. Lets require all financial institutions to mark their assets to market, but not hold that against their capital. In other words - the reason the stocks have gotten destroyed is because they look undercapitalized when marking down their assets, but if the regulators do not require the company to hold that mark against their capital then - voila! they are not undercapitalized anymore. The companies would still of course be required to show MTM values etc. allowing investors to determine the underlying value of the stock. This solution would effectively do away with shorting these stocks to oblivion on the assumption they are going to be required to raise more (dilutive) capital.