Murray Draft 1

Mark-to-Market and its Role in the Current Economic Crisis
Ron Murray FIN 623 (Fall 09)

Is simple accounting the reason for our world’s current financial crisis? Could a group of men and women in a back room, wearing green hats, their pocket protectors full of pencils and red and black pens and their 10 key calculators a blazing, have banded together and caused this world wide financial meltdown?
Accountants, and more specifically the Financial Accounting Standards Board (FASB), are responsible for “Mark-to-Market” accounting. This form of fair value accounting has been at the topic of several discussions ranging from the leaders of the largest corporations in the world to colleagues having their morning water cooler discussions.
Mark-to-Market (MTM) accounting is the practice of “marking” or setting the value of assets on a company’s balance sheet to the fair market value on the date of the balance sheet report. There are several applications of Mark-to-Market, but this article will focus on the use of MTM in valuing balance sheet assets and what affect this may have had on the current economic crisis.
Mark-to-Market History
Mark-to-market was first developed and used among traders on futures exchanges in the 20th century. During the 1980s the practice spread to the big banks and corporations and became widely accepted as part of Generally Accepted Accounting Principles (GAAP) in 1993 under FAS 115.(1) At the center of debate currently, is FAS 157, which was issued in September 2006 and was made effective for corporations with fiscal years beginning after November 15, 2007.
FAS 157
This following excerpt directly from FAS 157 explains why it was issued: “Prior to this Statement, there were different definitions of fair value and limited guidance for applying those definitions in GAAP. Moreover, that guidance was dispersed among the many accounting pronouncements that require fair value measurements. Differences in that guidance created inconsistencies that added to the complexity in applying GAAP. In developing this Statement, the Board considered the need for increased consistency and comparability in fair value measurements and for expanded disclosures about fair value measurements.” (2) I understand this to say that the intent of this standard is to allow investors to better understand the values of assets a company is holding. This will allow investors to make more informed decisions.

The critical areas FAS 157 addresses are:
• Clarity on the definition of “fair value”
• The notion that fair value is market based and not entity specific
• A fair value hierarchy (Level I to Level III)

The first item of business in FAS 157 was to clarify “fair value”. FAS 157 defines “fair value” as “The price that would be perceived to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.”
FAS 157 also emphasizes that the notion of fair value is market based and not entity specific. This means that when a company is attempting set assets at fair value, they must consider the open market. Thus, the optimism that often characterizes an asset acquirer must be replaced with the skepticism that typically characterizes a buyer. Again, not what the company feels an asset is worth, but what a realistic buyer would pay for the asset.
Finally, the area that I feel has caused the most emergency manager meetings after regular working hours is the fair value hierarchy that was established by the FASB in issuing FAS 157. The hierarchy calls for assets to be placed in three separate levels, all with their own valuation techniques.
Level I assets are assets that have readily available market prices. This would be as basic as owing shares of Caterpillar stock. A company that owns Caterpillar stock can obtain a market value for that stock at any minute during the day. At quarter end they simply value the stock based on the quoted price at the close of business that day. Oh, if it could all be this easy.
Level II assets are assets that do not have readily available market prices. An example of a Level II asset would be shares of a privately held company. Since these assets don’t have readily available market prices they are valued based on models. The model is fed with observable inputs for which there are market prices (prices of similar securities, interest rates, etc.). (3)
Level III assets, like Level II assets, do not have readily available market prices. The big difference is that there are also no viable inputs to feed into a model as with the Level II assets. This leaves management with the ability to make assumptions about the input’s values that are being used. A prime example of a Level III asset is a mortgage backed security. (3)

The Fall Out
The preverbal bursting of the housing market is what many will agree played a major role in fueling this current economic crisis. How is this affecting the banks and marking assets to market? First let me start with an example that I found in Paul Warkow’s article Mark to Market – The Real Reason Behind the Financial Crisis:
Let us imagine that you own a house in a neighborhood where all houses are identical and are all worth about $300,000. Unfortunately, your neighbor has a personal crisis and needs money right away. Because this person is under duress, the home is sold for $200,000. Does that mean your home or other houses in the neighbor are worth $200,000? Of course not, but if you were a publicly traded company, by law you would have to list your house at a value of $200,000, not the $300,000 you would want if you sold it. How does this principle apply to banks?
Let us say we decide to start a bank, call it XYZ bank. We raise $2 million to start. That means our capital account has $2 million. Remember, banks make money by taking in deposits and paying low rates of interest and lending it out at higher rates of interest. When we open the doors to XYZ bank, we take in $30 million in deposits. We turn around and take that $30 million and lend it as mortgages. Our capital account is $2 million and our loans are $30 million. that is a ratio of 15:1. Under banking laws, this is a perfectly acceptable ratio.
XYZ bank does not make risky loans. All our mortgages go to people who put down at least 20%, a credit score over 800 (which is almost perfect), have assets in bank accounts that are 10 times the monthly mortgage payment (normal is two months) and the monthly mortgage payment is only 10% of the borrower's monthly income (40% is normal).
We do this and our loans perform perfectly. We make lots of money. Nobody is late, every one pays not only on time, put even early. Our depositors and borrowers love us and we are making lots of money. We break out the champagne as our stock prices and our profits rise.
Now the housing crisis hits and real estate values decline. Even though our customers continue to pay on time and every loan is performing perfectly, we must re-assess our mortgage portfolio to account for the decline in real estate values. Under mark to market accounting, since real estate values have gone done, the mortgages on the houses become riskier, even though everyone is paying on time. We must reduce the value of our mortgages from $30 million to $29 million to reflect that the mortgages are riskier. It is a paper loss, we do not write a check, no defaults, no late payments and no bad business decisions. Still we must reflect this $1 million dollar paper loss by reducing our capital account by that same $1 million. Our capital account, which was $2 million,is now valued at $1million.
Now we are in trouble. We have $30 million of mortgages outstanding and only a $1 million dollar capital account (on paper). The ration is now 30:1 Our ratios are now out of banking compliance. The FDIC puts on a watch list, the Securities and Exchange Commission (SEC) is asking questions. CNBC is now reporting that we are in trouble. What do we do? We have to raise an additional $1 million dollars to raise our capital account back to $2 million. This is unlikely because nobody will invest in a bank that is on FDIC watch list and being investigated by the SEC.
The other option is to sell assets, like the outstanding mortgages. Like your neighbor in the first example, we need to raise cash fast, so we sell the outstanding mortgages quickly. This will further reduce the value of the mortgages we have on the books. It is a vicious cycle as our bank starts to spiral down. What did XYZ bank do wrong? The answer is nothing. This was all caused by the mark to market pricing requirement. The problem does not stop with XYZ Bank.
The fire sale that we just had on our mortgages males things worse for the banks that bought our mortgages for a great price. Under Mark to Market, the mortgages we just sold must be used as comparable that other financial institutions use to value their assets. This is how the problem spread and things went bad so fast. Other good institutions had to de-value their loans and just like XYZ Bank, were over leveraged. This caused a chain reaction, caused be a well intentioned, but harmful accounting rule.
As a result of this chain reaction, financial institutions fold, sell or freeze credit. The life blood of our economy is choked off, which has caused this mess. It is clear that the mark to market rule has to be modified as it relates to loans. This will go a long way to help us out of this crisis. (5)

I believe this example really lays out the current predicament very nicely. But how does this tie to FAS 157 you might be asking.

The issuance of FAS 157 sent many of the world’s largest companies, and more importantly, banks reeling. In November 2007, Stephen Taub of CFO.com noted that several of the large banks would take massive hits from this new standard in financial reporting. For example, at the time of the issuance of FAS 157 Morgan Stanley had an equivalent of 251 percent of its equity in Level III assets, Goldman Sachs 185 percent, Lehman Brothers 159 percent and Citigroup 105 percent. On the other end of the spectrum, Merrill Lynch had only 38 percent of its equity tied up in Level III assets. (4)

Bibliography

1. http://en.wikipedia.org/wiki/Mark-to-market

2. FASB Stmt 157 – (http://www.fasb.org), Issued September 2006

3. http://www.fool.com/investing/dividends-income/2008/10/02/ - Mark-to-Market What You Should Know October 2, 2008

4. http://www.CFO.com/printable/article.cfm/10097878 – FAS 157 Could Cause Huge Write-offs November 7, 2007

5. http://ezinearticles.com/?Mark-to-Market---The-Real-Reason-Behind-the-Financial-Crisis&id=2080848 – The Real Reason Behind the Financial Crisis March 9, 2009

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