Marking to Market

One of the factors that has supposedly fueled the current financial crisis is the mark to market rule. Under this rule, financial firms must keep securities on their books at the market price. The idea behind mark to market was to provide greater transparency into a firm's real value by providing a close to real time snapshot of the value of its holdings. However, in a declining market, the mark to market rules have forced companies to write down the value of securities to the point where the firm itself may appear insolvent. At this point rating agencies have no choice but to downgrade ratings which may force firms to increase collateral on loans, trigger default covenants in loans and make firms unattractive borrowers. Accordingly, some have called in the current crisis for relief from mark to market rules which make an entire firm's solvency dependent on the vagaries of the market.

While there is something to the argument that mark to market accentuated the current crisis, as John Kay writes today in the Financial Times, problems with mark to market in a decline are nothing compared to mark to market in a rising market.

Jeff Skilling at Enron supposedly broke open bottles of champagne upon receiving an SEC letter allowing Enron to make wide use of mark to market rules. The SEC ruling allowed Enron to book unrealized fluctuations in the value of securities as profits. As Kay notes, it gave Enron instant credit for the discounted present value of traders' ideas at the moment of inspiration--regardless of whether the ideas ultimately panned out. Under this logic, Sir Isaac Newton should have been a very rich man until the theory of relativity wiped him out. As Kay explains mark to mark during the bull market in housing and stocks that preceded the current financial crisis, helped bankers, prop traders, hedge funds and others make huge profits out of nothing.

Ultimately, behind the mark to market debacle is the central belief of our age: boundless, unlimited faith in markets. As Adam Smith discerned, markets are a wonderful way to allocate scarced goods relative to the alternative--some version of central planning. However, the same enthusiam cannot attach to the wide gyrations in market prices as money sloshes around the globe that clearly reflect not only animal spirits but old fashioned chaos, accentuated by human passions. The wild gyrations of the last few weeks are not guides to long term value. While instant prices are a tool in understanding value, they should not be the final word. Interestingly, even free market zealots like Newt Gingrich have come out in favor of suspending mark to market rules because of their impact in downturns. But as Kay points out, our real concern should be their impact in upturns.

It is time to re-examine the mark to market rule--and the idea behind it that market prices are infallible.