Understanding the Significance of Mark-to-Market Accounting

"Suspending mark-to-market accounting, in essence, suspends reality."

–Beth Brooke, global vice chair, at Ernst & Young

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Misinformation, bad dope, and spin seem to be dominating the current discussion on Mark-to-Market accounting. Let’s see if we cannot simplify the arcane complexity of the accounting rules regarding FASB 157.

Understand why this is even an issue: Many banks, brokers, and funds chose to invest in certain "financial products" that were difficult to value and were at times thinly traded. If you are looking for the underlying cause of why some arcane accounting rule is an issue, this is it.

In my office, we don’t buy our clients beanie babies or Star Wars collectibles or 1964 Ferrari 275GTBs. We purchase stocks and ETFs and bonds and preferreds for them (some clients also own options and commodities). Why? Because we believe — and our clients have insisted upon — the need for instant liquidity. Nothing we have purchased cannot be liquidated on a moments notice. We know what the fair value of these holdings are second by second.

While we may have been tempted by potential greater returns that
some of these other products offered, we simply could not justify the
risk of owning hard to value, thinly traded, hard to sell items. And, we never had to rely on the models of the individuals who created and sold us these products in the first place, to determine an actual price. If ever a product was rife with self-interested conflicts of interest, this one is it.

That is one of the key elements of the current situation. A decision was made to bypass the broad, deeply traded traditional markets (Equities, Fixed Income, Commodities and Currency) and instead create new markets for new products. No one should be surprised that the net result was a flawed system of garbage paper, with too little room at the exits in case of emergency.

Let’s puts this into some context:

"Accounting is a way of portioning economic results by time periods. It
doesn’t affect the cash flows, but tries to allocate economic profits
proportional to release from risk. If we were back in an era where the
financial instruments were simple, then the old rules would work. But
once you introduce derivatives, and securities that are called bonds,
but are more akin to equity interests, you need to mark them to market."

–David Merkel

Exactly. Otherwise, you are left with public companies, who have made capital allocation and investment decisions that are hidden from their owners (shareholders) and the investing public.

Now that the garbage is on the books, no one wants to admit the original error of purchasing this class of assets. Its not just that the trade has gone bad, its the original buying decision was so flawed even if the trades were not such giant losers.

Recent actions of corporate titans in the financial sector are essentially an admission that their business model was deeply flawed. No one would invest any capital for a ROI of 50 bps per year. They of course knew this — so they leveraged up that 50 bps 35X or so, creating the false appearance of more attractive returns. This higher risk, potentially higher return paper was part of that misleading process.

Suspending FASB 157 amounts to little more than an attempt to hide this broken business model from investors, regulators and the public. Its not just getting through the next few quarters that matters; Rather, its allowing the market place to appropriately reallocate this capital to where it will serve its investors best. That is what free market capitalism is, including Schumpeter’s creative destruction. (A WSJ OpEd today get this issue precisely wrong).

I have been steadfast over the past 2 years about why I did not want to own any of the financials that held this paper on its books. The key was that we could not figure out what the liabilities were relative to the assets. That is investing 101.

If FASB 157 is suspended, I would advise our clients and the investing public that owning any financials that failed to disclose their holdings accurately were no longer investments — they were pure speculations, with more in common to spinning a roulette wheel than owning Berkshire Hathaway (BRK) or Apple (AAPL) or Google (GOOG). Indeed, I know of no faster way to end up on the DO NOT OWN list than to hide from your shareholders what is on your books.

If investors cannot trust the valuations of what is on a firms books, they simply cannot invest in these firms PERIOD.

There are other alternatives for the institutions that now must deal with this discounted, thinly traded hard to value junk paper. They can sell it for whatever price a the market will bear, they can spin it off into a separate holding company, they can write it down to zero and reap the rewards of mark ups in future quarters.

But suspending the proper accounting of this paper is the refuge of cowards. It reflects a refusal to admit the original error, it hides the mistake, and it misleads shareholders. I find it to be totally unacceptable solution to the current crisis.

As Japan learned, not taking the write downs only delays the day of reckoning. They propped up insolvent banks, and suffered a decade long recession for it. That way disaster lay . . .

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Previously:
S&P500 ex-Risk ? (November 06, 2007)
http://bigpicture.typepad.com/comments/2007/11/sp500-ex-risk.html

Sources:
Summary of Statement No. 157
Fair Value Measurements
http://www.fasb.org/st/summary/stsum157.shtml

Auditors Resist Effort To Change Mark-to-Market
JUDITH BURNS
WSJ, SEPTEMBER 30, 2008, 4:29 P.M. ET
http://online.wsj.com/article/SB122280147924091325.html

SEC, FASB Resist Calls to Suspend Fair-Value Rules
Jesse Westbrook
Bloomberg, Sept. 30  2008
http://www.bloomberg.com/apps/news?pid=20601087&sid=agj5r6nhOtpM&

How to Start the Healing Now
Fix accounting rules and private money will come.
BRIAN WESBURY
WSJ, OCTOBER 1, 2008
http://online.wsj.com/article/SB122282734447293049.html