A Novel Criticism of “Mark-to-Market” Accounting Rules

One of the many ways hat Obama is artificially inflating the value of bank stocks is by allowing “mark to market” accounting rules.

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Bankers often complain about mark-to-market accounting rules these days. To see what they wish for, and how they would have to value their assets in order to operate like other actors in the global marketplace, consider the following thought-experiment.

Say you have $6. You spend $5 of that monie on a can of coca-cola, because you are foolish and easily tricked. You now want to go into the insurance business, but because this means that the quality of life of many people you do not even know would be in your hands, the government has regulations to make sure no fly-by-night insurance companies run by foolish and easily tricked CEO get off the ground.

“You can be in the insurance business,” the government official says, “as long as you prove to me you have at least $3. This way, we know you aren’t a complete fraud or loon.

“No problem!” you say. “I have $6! $1 in cash, and $5 worth of one can of coca-cola!”

At this point, the government regulator gets a headache from your attempt to make him as recklessly optimistic about pop can futures as you were, and points you to a sign. “Mark-to-market accounting rules only.” “I’m sorry,” says the regulator,” but unless you can prove that someone, somewhere, is selling the can of pop for $5, you can’t say it’s worth $5 to me. That means, you can’t go into the insurance business!”

This is what bankers are complaining about. Why aren’t the assets they bought for a price accounted for according to that price? Why can’t their wishes become your reality?

But, in this thought experiment, you go outside, and check all the stores, gas stations, and pop machines for their prices. Walmart is selling pop for a quarter. The machine at Target is going for 50 cents, and the machine at your kid’s school is at 60 cents. In the mall a can costs $1, and at the airport across town is a machine selling a can of coca-cola for $2.

Eureka! You found it! You can go into the insurance business! And if a plane crashes, a trail derails, or a comet strikes, you’re covered! You can just sell your cans of cola for $2!

Now for several years these are going well. Of course, you complain that the government is only allowing you to “mark-to-market.” Go to the movie theatre (it’s closer than the walmart, and you need them now!), buy a can that cost about 12 cents to distribute, and is for sell elsewhere for 50 cents, for $5 (as I said, your foolish and easily tricked). Account for it as $2 (because that’s what their charging for it at the airport), and sell insurance policies. You’ll need to borrow money for this, but you secrelt know (somehow) that the real value of the pop can is at least $5. For every $2 in policies you sell, you “cover” it with $2 worth of a pop can you paid $5 for, but expect to get rich from in the future! What a profit! life is good!

But then tragedy strikes. A plane crashes, a trail derails, and a comet strikes. Many houses burn down. People look to you for money. You don’t have it. Cash if fact, capital is theory, and you are sort of funds and way long on pop cans.

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So what do you do? Declare pop cans to be “toxic assets,” go on the Treasury Department, and demand a bail-out. Blame mark-to-market accounting while you’re at it, because the market price for pop cans (a measily $2, according to your accounting) is artifiicial low! You paid $5 for them!

Fortunately, in this thought experiment you have made the right friends, and your pals in the White House and Congress give you billions to cover the cost of insurance policies you sold, but could never cover in the first place. At first the government says you need to pay them back (the government takes preferred shares in exchange for the money), and then when you complain loudly enough, the government clarifies that you only will need to pay some fraction of the profit you make when pop cans magically cost more than $5 (by converting the preferred shares into common shares).

So what do you do? Go on CNBC, and complain about mark-to-market accounting rules! They are making you account for your wealth at only $2 a can, instead of $5, even when there are “no buyers.” (By this, you mean that only people nearly as optimistic and risk-taking as you will pay $2).

This is how mark-to-market accounting rules work. Mark to market accounting rules work as a bailout to banks, buy allowing them to list assets at prices too high to sustain regular market operations. The price of the marked-to-market assets only appears to be as high as it is because the banks aren’t selling the assets they do have. The price required to find many buyers is much lower than the price to find just a few buyers. In the same way, you can probably find someone willing to pay $2 for a can of coca-cola. If you want to sell a million cans, however, you’re looking at something closer to 50 cents.

9 thoughts on “A Novel Criticism of “Mark-to-Market” Accounting Rules”

  1. The fundamental flaw in this is the banks are not arguing the can of coke is worth what they paid for it, they’re arguing it’s worth more than the value some accountants pulled out of thin air because nobody will buy any coke at any reasonable price because there is a scare that many cokes are contaminated – knowing full well that a majority of the cokes are not contaminated. Selling at panic prices would not be smart.

    Also, I really know of no bankers of any significance arguing for relaxing mark-to-market accounting rules. Changing the rule came to my attention when the idea was floated out a research group run by the Republican congressional delegation, and it was advocated by Newt Gingrich and John McCain last fall. It was actually put forth as an alternative to TARP, and cited by many critics of TARP as a much better approach to dealing with the credit crisis.

  2. The fundamental flaw in this is the banks are not arguing the can of coke is worth what they paid for it

    Indeed, but this is not a flaw in the parable. In the story, the coca-cola can investor is quite happy, when mark-to-market rules allow him to price his can of coke as $2, because that is the very upper end of what the market will tolerate.

    they’re arguing it’s worth more than the value some accountants pulled out of thin air

    I agree that there is some arbitrariness of mark-to-market, but here you have it backwards. The price is not out of thin air, it is the very upper bound of what they can find a seller for, even if the price is so high that it is above a sustainable market price.

    will buy any coke at any reasonable price

    “Reasonable” here being defined as a price that allows an investor to recoup most of his investment, and (not coincidentally) roughly matches the long-term value of the property he calculated when he purchased it.

    The NASDAQ index is reasonable as 5000, by the same standard.

    many cokes are contaminated – knowing full well that a majority of the cokes are not contaminated

    Well, if by “contaminated” you mean “perhaps not actually coming with $5 worth or utility,” then the first part of your claim is right, and the second part more questionable.

    Selling at panic prices would not be smart.

    I am sure many NASDAQ investors, when the index was down to 3000, figured the same.

    In time, they may actually be proved right.

    Thanks for the comment!

  3. I am not sure I follow the argument. I think you have it 100% reversed though other times you don’t. TDAXP, are you saying the market price is inflated over the “true” value?

    How is Mark-to-Market inflating bank stock prices? BTW, I am against removing the Mark-to-Market.

    What alternative do you suggests for valuing these assets – since much of the data is crap that is feeding into the risk models (which are flawed)?

  4. Mark to market is a hot topic:

    “NEW YORK (Reuters) – The Financial Accounting Standards Board, which sets U.S. accounting rules, will discuss mark-to-market accounting guidance at its board meeting on Monday, according to its website.

    The board says it will discuss “additional application guidance” that would clarify how mark to market is used in illiquid markets, according to the website. …” –

    http://www.reuters.com/article/gc06/idUSTRE52C6FX20090313

    ‘Edward L. Yingling, the president of the American Bankers Association, says the proposal addresses “systemic risks that accounting standards can have on the economy.” …’

    http://www.nytimes.com/2009/03/13/business/economy/13norris.html?em

    My prediction stands, when the autopsy all done, the mark-to-market accounting rule is going to get far more blame than CDOs and CDSs. There simply is no way for mark to market to work when the market is frozen – panicked. The loss provisions were way too big. This is the United States of America. Our stuff is not pond scum.

  5. Purpleslog,

    Thanks for the comment.

    I am not sure I follow the argument. I think you have it 100% reversed though other times you don’t. TDAXP, are you saying the market price is inflated over the “true” value?

    How is Mark-to-Market inflating bank stock prices? BTW, I am against removing the Mark-to-Market.

    What alternative do you suggests for valuing these assets – since much of the data is crap that is feeding into the risk models (which are flawed)?

    Prices are set by an interaction of supply and demand. I will leave questions of “true value” to theologians and Marxists.

    That said, the accounting of a thing should flow from the purpose of the accounting.

    I dot not know what the purpose of the accounting of the assets that are under discussion is.

    Let’s assume for the sake of argument that the purpose of stating a value is to establish that a bank can survive a run, and is a viable concern. In such a case, the proper accounting of the goods should be the price that the bank could get from them if it had to rapidly liquidate. If this is true, then mark-to-market is a backdoor subsidy for a bank, as it is using a “market price” that is too high to allow a fluid market to account for a product that needs to be liquidated.

    You may well be able to sell your $2 cola at the airport. If you need to move a truckload of inventory by the end of the day, however, $2 is deluisionally high.

    sonofsamphm1c,

    Thanks for the news, and the commentary.

    My prediction stands, when the autopsy all done, the mark-to-market accounting rule is going to get far more blame than CDOs and CDSs. There simply is no way for mark to market to work when the market is frozen – panicked. The loss provisions were way too big. This is the United States of America. Our stuff is not pond scum.

    The market is ‘frozen’ (that is illiquid) because the price is too high. In the same way, the market for 1995-era Packard Bell computers that I’m selling for $10,000 is ‘frozen.’ So is the market for $3 cans of coca-cola.

    As to whether it is reasonable to account for a good at the highest price one can sell a small number of it for (mark-to-market), a liquidationprice, or something else — that goes into the purpose of accounting for these goods, which I am not aware of.

    The FASB news is interesting. It comes on the heels of Geithner denying there are any zombie institutions, and large banks saying they won’t need more federal funds. It seems like the Obama administration is using accounting changes to subsidize banks, in an environment where it is politicly costly to keep writing them checks.

  6. FASB is trying to somewhat undo a horrific calamity their rule inflicted on the global economy. Their rule was woefully schemed to deal with a market panic, and it did colossal damage – somewhere around 10 to 35 trillion in grandpa and granny wealth vamoosed.

    The prices were not too high. Lynch, in a dire emergency, sold around 30 billion of LDOs for 20 some cents on a dollar – and they had to loan the purchasing company the money. That was essentially, what, approaching for free:

    http://www.lonestarfunds.com/En/lonestarfunds_vi.htm

    Then they forced banks to start writing off 70 to 80 cents on the dollar on financial instruments where 92% of the interest payments were coming in every month. This was a gigantic mistake.

    Anyway, I think Obama-Geithner and Bernanke are steamrolling toward financial stardom. It’s a very solid recovery plan. Blows away the Lemmings and the cliff jumping notions.

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