Mark-To-Market Accounting…Is this system to blame for our financial crisis?

Okay Peachtree City, I heard all kind of scuttle-butt related to President Obama’s take on correcting the financial structure of our country and supposedly suspending this system.  Now I know your next question will be, “What the heck is Mark-to-Marketing and how is it related to our current financial crisis?  Remember Enron and Worldcom and a host of other unscrupulous companies that bilked investors out of billions.  Yeah, somebody cooked their books!  Unfortunately not to many folks knew how.  But the real question here may be, “Could our financial meltdown be pinned down to something as simple as an obscure accounting rule?” 

Maybe so…remember this rule was so devastating that FDR suspended it in 1938.  So why would the Bush administration resuscitate it again in 2007.  I know Forbes reported additional catastrophe and casualties resulted from the short sales of stock which went unseen and unenforced by the SEC picking off a huge number of solid companies.  Anyway this post is not about politics but about understanding our plight.  So let’s look at the facts!  But first what is Mark-to-Market?

Simply defined, Mark-to-Market is where companies reprice or Mark their assets on a daily basis to the most recent market transaction price. So if a company assets prices are tanking, this would mean that the value of their assets on the banks or the company’s books drops.  When the total value of assets fall, then those who have lent them money get really antsy.  Why?  Because the assets they lent the company money against now are worth less.  So if the company all of a sudden can’t pay back the loan, the lender is in deep water.  Of course then the lender is going to demand that the company immediate raise some cash or add assets to increase their asset totals.  If the the company cannot comply, the lender steps in and either takes back enough assets to cover their loan, or find some other way to cover the loan amount.

Okay folks, it is no secret that the epicenter for the current economic crisis resulted from trillions being
lost in the mortgage meltdown.  Heck, for years Wall Street has been cooking up all these risky investment
vehicles perpetrated through structured financing.  Finally, all these risky sub-prime mortgages were neatly package and gift wrapped into lucratively attractive investment securities, called collateralized debt obligations (CDOs). Then all hell broke loose as the bottom fell out as home prices plummeted and foreclosures soared.

Now, if I remember correctly to determine an assets book value it is basically the cost of the asset minus any depreciation.  On the other hand, the market value of that same asset would be be the price the market would bear if that asset was sold right now!  However, companies valuation of their assets is another story.  Yes, most companies use accepted rules and practices to determine book valuation.  Also, if I’m not mistaken the SEC and the Federal Accounting Standards Board required companies to use mark to market valuation on all their mortgage-backed securities.  However, as you probably assessed, these complicated algorithms or derivatives used to compute the valuation of an asset have short-coming and can be easily manipulated. Basically, it is a fact that a company’s market value assessment has fallacies due to the fact that there is no guarantee that any future transactions will result in similar values for that asset. That determination can’t be known until the company actually tries to sell that asset.

Looking at the big picture, Federal Reserve Chairman Ben Bernanke basically stated at a meeting in London a few months back that as long as the presence of all these toxic assets have the propensity to lose its
underlying value banks are at risk of more contradictions and the confidence of investors will remain skeptical.  Therefore banks will continue to be conservative and lending constrained. President Obama may have eluded to his impending action as he stated in a recent interview with Matt Lauer of NBC when he stated that “…some banks won’t make it!.”    

Getting back to Mark-to-market…in my research I found the perfect example in a recent Forbes article;
As a Rod Sterling monologue would always start, Picture this….you a typical homeowner in a bustling suburb south of Atlanta.  You have a spouse, two kids and a $200,000 mortgage on a $300,000 house that you planned on residing in for next 20 years. Now picture your neighbor, a cancer patient needing money
for a major operation…sells his house for $150,000.  Okay, now imagine that your banker said you had to mark to this “new market” and fork over to the bank $80,000 in cash immediately (so you would have 20% down) or lose your home.  Yes, you have just entered the Twilight Zone and although this may not be reflective of a real life scenario, but if it were true…Would this create absolute mayhem?

So what’s happening is that investors are facing risks that have nothing to do with asset quality but are questionable because of this accounting principal.  As mentioned earlier, also exacerbating the situation are short sellers using capital requirements as leverage to drive down the price of assets and creating a fire sale environment.  It it starting to make sense to you?  Well, I always suggest that you do your own research.  The big question is that could this change actually bring a bottom to the market’s downward spiral.  Well it at least sounds to me like a great starting point for at least some discussion and further consideration by our country’s experts.  I’m also more interested in the probability of this proposal because it involves less government intrusion and intervention. 

On the other hand, (of course, I will always try and present all sides) I know that there will also be opponents to suspending this rule.  In some instances, I also see how it works.  Further, what would be an effective replacement?  Well, as a real estate professional and not an economist or accountant, I don’t have the answer and I hope that I presented a good enough scenario for readers to get a grasp of what is going on.  The complexity of some of these financial issues are difficult for the average person to understand.  Accounting principles, derivatives, and of course all these financial products.  However I am astute enough to see sufficient evidence that suggest that Accounting seems to be more reflective of Art than Science.