Dealing with Mark to Market
New York City - Last fall, I wrote about an obscure accounting rule contributing to the financial crisis. Trillions of dollars in taxpayer outlays and guarantees later, it is time to revist the subject.
Since the financial crisis began last year, many commentators have pointed to an obscure accounting rule as playing a major role in the the crisis. Called mark to market accounting, the rule requires public firms to reprice their assets every quarter, and in the event of a decline, take a huge paper loss.
Supporters--principally accountants and advocates of shareholder rights--defend the rule on the free market principle of transparency. Opponents who include many in Congress, say forced writedowns on illiquid assets to fire sale prices for the last year is illogical and has led not only to the losses booked by large financial insitutions in the last year, but also to the need for billions in taxpayer bailouts.
Mark to market is not controversial for easily priced assets such as those traded on exchanges. However, in 2007, the FASB which writes these rules issued a modification known as FAS 157, which instructed firms to begin repricing so-called Level 3 assets--those which by definition are extremely hard to value. That change took effect last year and has helped drive many of the paper losses that have roiled the economy.
For banks, venture capital funds, hedge funds and others that hold illiquid investments like stakes in Internet companies and untraded derivatives, mark to "make believe", as it is known is not easy. How, after all, do you value an investment in an Internet company that has yet to turn a profit (think YouTube before its sale to Google), or a mortgage backed derivative when buyers disappear. The answer, more often than not, is an arbitrary guess.
A valid criticism of all mark to market for untraded assets is that it's pro-cyclical, promoting exuberance in good times and fear in bad ones. Enron officials loved mark to market in the year 2000, as I wrote last year, because it let them report paper profits as they marked up their portfolio, inflating their stock price. During the real estate bubble a few years ago, mark to market also fueled the upward trend.
Falling markets, however, exaggerate losses on the downside. In the last year, the rule has forced holders of illiquid assets--those firms whose names have been in the news--to take huge losses on paper that the government has had to staunch with real funds from the TARP supplied by taxpayers. Today, fear of mark to markdowns lies behind uncertainty that continues to block the flow of credit through the economy.
While the SEC oversees accounting standards, it has traditionally outsourced them to the Financial Accounting Standards Board or FASB. Bush SEC Chairman Cox was especially loathe to tackle the issue. The Obama team may be more open to action on this issue that has reportedly been a hot topic of debate in the White House.
The reason is that escaping mark to market may be a requirement of the Geithner plan to entice private investors to buy up troubled assets. Markdown risk is a disincentive to private investors even going into the deal proposed by Secretary Geithner, let alone paying a reasonable price for assets.
The government could offer investors in distressed assets a special deal. However, that would raise the question of fairness. One approach would be to extend a guaranty to distressed assets for those who buy them from current owners. However, this raises the question, why should taxpayers foot the bill for a trillion dollar guaranty that could have been reduced or eliminated with a press release from the SEC modifying a rule that only took effect last year. (Practically speaking, tweaking the rule would involve a clarification from the SEC to explicitly prevent revaluations of illiquid securities.
It also raises the broader question, given the trillions of losses the taxpayer has borne and is now facing--and the collapse of faith in markets around the world that may alter our relationship with markets for a generation--whether defending an obscure rule that didn't even exist until 2007, is worth the spectacular cost. Shareholder rights advocates may be missing the forest for a tree.
Changing treatment of illiquid assets might also give the Administration breathing room to implement its plan. The rule in question introduced only in 2007 at the height of market fundamentalism is hardly an American tradition. It is time to deal with this issue.
