Mark-To-Market Disaster

I was on a flight the other day on my way home from LAX and struck up a conversation with a nice lady sitting across the aisle from me. As it turns out, she was a partner with a major accounting firm. When I found that out I couldn't help myself; I just had to get her take on my theory about the origins of the current financial crisis.

As a result of the stock market bubble of the late 90's and the Enron debacle, congress and the SEC instituted a number of accounting changes, one of which is called "mark-to-market" or fair value accounting. You see, many financial institutions were holding on their balance sheet assets at their original cost, not necessarily what the assets were worth. In some cases, assets were held at far higher values than the asset's true intrinsic value. This created false assumptions about the strength of many companies' balance sheets, leaving many investors shocked and dismayed at their sudden collapse when these problems came to light. To "fix" the problem, the government determined that assets must be held on a company's balance sheet at the "fair market value" derived from what the asset would be worth if were sold today. Sounds fair enough, that is unless no fair market exists. And that, my friends, is one of the major causes of the financial distress the markets are feeling today.

You see, we now have a massive dislocation of credit markets. It started with the crisis in the sub-prime mortgage market (more on this later). Many of these mortgages given to less credit-worthy borrowers began to become delinquent and because of the complicated structure of the securities in which these mortgages were held, the buyers of these securities had great difficultly in determining their value. As a result, the prices of those mortgage backed securities (CMO's) began to fall precipitously...and fall...and fall. In fact, while many of the securities showed delinquency rates of less than 10%, they were priced as if 50%+ would eventually default. This is where mark-to-market comes in. You see, banks and financial institutions that hold these types of securities had to mark these securities on their balance sheet down to the current market value, even if they had no intention of selling the assets. But no fair market existed. And every time these securities had to be marked down, the banks had to raise more cash through asset sales or equity issuance and they would reduce lending in order to meet their capital requirements. This became a debt spiral. There were few or no buyers of the securities so the market value continued to plummet. The banks then had to mark these assets down even more or sell them into a panicked market, and they had to sell common or preferred stock diluting their existing shareholders and sending their stock prices down. And all this had been happening while most of those mortgages in the CMO's continued to be paid. In fact, the intrinsic value of those assets, determined by the expected cash flow of those assets, continues to be far higher than the market price in this dysfunctional market.

What the government must do is immediately implement "mark-to-model" accounting. What this does is require companies to hold assets on their balance sheet at a value determined by the expected cash flow if those assets are held to maturity, unless the company is holding those securities for sale or in a trading account. They should not be forced to mark these assets to market value when no functioning market exists. It also would not allow these assets to be held at cost. And it should be the government's job, as the regulator, to provide guidelines about expected default rates and assure that reasonable cash flow models are used.

If mark-to-market accounting were implemented, immediately the vast majority of banks and financial institutions would become liquid and solvent. These institutions exist to make money and they make money by lending. Lending would increase to normal levels and markets would regain their ability to function. End of financial crisis. Recession, yes, but recover would be much quicker.

Oh, yes. The nice auditor at the major accounting firm on the flight with me agreed. Smart lady.