Murray Final

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. BY making the financial statement more transparent, this allows 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 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 or stock options. 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 the 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 in the model. 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?
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)
For many years banks have been bundling their mortgages and buying and selling them on the open market as mortgage backed securities. In the past they were easily valued because they were much more uniform. Now there are several variations of mortgage backed securities making it extremely difficult to value them. When many of the subprime loans began defaulting, these securities became toxic. So what we have is a large number of banks with these sub-prime securities on their balance sheets. The problem is that the market for these new mortgage backed securities is fairly new and there are no other markets similar to it. Also, since the values of these are very uncertain companies have stopped trading them. This has made valuing them extremely difficult.
With the inception of FAS 157, banks have been writing down these toxic assets to negligible market values. The World’s largest banks have written off between $250 - $300 billion in bad assets since the housing bubble burst in 2006. Because of this, banks have had to raise extremely large amounts of capital within the last 2 years. This has come from many sources including this country’s government (TARP), sovereign wealth funds of other countries' governments and public investors.
Following is an example that I found in Paul Warkow’s article Mark to Market – The Real Reason Behind the Financial Crisis. I believe it does a nice job of explaining the predicament that banks have been in since the inception of FAS 157.
“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 down, 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.
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.
The fire sale that we just had on our mortgages makes 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.” (5)
I believe the example above really lays out the current predicament pretty nicely. I would argue though that if the person sold his house for $200,000, then that is indeed the “market” or something very close. Remember, market price is only what someone in the open market is willing to pay you for your particular asset. I know if I go into a neighborhood and all houses are “worth” $300,000 but a house recently sold for $200,000 there is no set of circumstances where I pay $300,000 for the next house. No matter the circumstances, the market was somewhat set when the original house sold for $200,000. Now, that’s not to say that a buyer that is less educated on the recent sales prices of the house won’t come in and pay $300,000, but I wouldn’t. I think you can see how this can get very confusing and difficult for mangers to estimate fair value.
But how does this tie to FAS 157 you might be asking. Recall, the person that sold his/her house for $200,000 was in a state of crisis. This is similar to the current state of the markets for many of these assets that are being written down.
It should be noted though that banks were writing down assets, because of defaulting loans, before the onset of FAS 157. It is estimated that there are currently $2 trillion in “toxic” assets on banks’ financial statements.

What’s Next
As a result of the problem discussed above, FASB was urged to lesson the requirements of FAS 157 and the Mark-to-Market rules. The general sentiment is that Mark-to-Market works fine in a stable or growing economy, but only worsens things in a down economy. The SEC recently conducted a study on Mark-to-Market accounting and concluded that fair value is generally supported by investors, but that there could be improvements to the application guidance associated with Statement 157.(6) In response to the recent inquiries by Congress and the banking industry, FASB has proposed FAS 157-e.

The purpose of FAS 157-e was to formulate a two-step process to determine when the market for an asset is not active and a quoted price for a transaction is not distressed. Remember, under FAS 157, these are Level III assets and have been valued in the past by assumption being made to the variables being input into the models used to value them. These assumptions are completely unknown now and it has made pricing them extremely difficult.

Step 1 of the plan is to determine when a market is not active. It is made up of the following considerations (6):

• Few recent transactions (based on volume and level of activity in the market). Thus, there is not sufficient frequency and volume to provide pricing information on an ongoing basis.
• Price quotations are not based on current information.
• Price quotations vary substantially either over time or among market makers (for example, some brokered markets).
• Indices that previously were highly correlated with the fair values of the asset are demonstrably uncorrelated with recent fair values.
• Abnormal (or significant increases in) liquidity risk premiums or implied yields for quoted prices when compared to reasonable estimates of credit and other nonperformance risk for the asset class.
• Significant widening of the bid-ask spread.
• Little information is released publicly (for example, a principal-to-principal market).

Once these are taken into consideration, a decision can be made by a company whether or not the asset is in an active market. It should be noted though that significant judgment will still be needed to make this determination. If an asset is determined to be in an inactive market the company then moves to Step 2. If on the other hand the asset is determined to be in an active market it can be valued appropriately at that time.

If an asset is determined to be in a market that is not active, the company moves onto Step 2, which is to determine if the quoted price being considered is associated with a distressed transaction. In step 2, the reporting entity must presume that a quoted price is associated with a distressed transaction unless the reporting entity has evidence that (a) there was sufficient time to allow for usual and customary marketing activities for the asset and (b) there were multiple bidders for the asset. If both a) and b) above are found to be true, then the quoted price is deemed not to be from a distressed transaction. If this is the case, the quoted price can be used to value the asset in question. Before using this quoted price though, a company should determine if it is a recent quote. If not, an adjustment may still need to be made.(6)

On the other hand, if both a) and b) above are not present, the quoted price is determined to come from a distressed transaction. This is where the leeway is now being given to companies. Companies would not have to mark the asset down using distressed quotes, but instead could use a different valuation method such as discounted cash flows. The variables used in calculating the discounted cash flows may now represent an “orderly” transaction between a buyer and seller, not a distressed transaction.

Again, ultimately all the above criteria involve judgment of top management. This will allow the banks to use fair value accounting without using market values. This won’t be as loose of an area of judgment as pre FAS 157, but it may resemble it. Although FASB made a strong stance with FAS 157, they have definitely backed off of it with FAS 157-e.

The new guidelines outlined above are effective for dates after March 15, 2009.

Where exactly will this new provision take us? Now that financial institutions are allowed to uses more judgment again, not quite as much as pre FAS 157 though, will this solve the financial crisis we are currently mired in? As always, only history will tell.

Sources:

(1) Mark-to-Market
Viewed April 2, 2009
http://en.wikipedia.org/wiki/Mark-to-market

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

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

(4) FAS 157 Could Cause Huge Write-offs
Stephen Taub
Seeking Alpha, March 27 2009 http://www.CFO.com/printable/article.cfm/10097878

(5) The Real Reason Behind the Financial Crisis
Paul Warkow
Ezine Articles, March 9 2009
http://ezinearticles.com

(6) Financial Accounting Standards Board
Minutes of the March 31, 2009 Board Meeting

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