The Mark To Market Obsession

The current debate about mark to market accounting is really a debate about assessing the ongoing viability of a financial company, especially a bank. Financial institutions and other companies are more than just a portfolio of their assets and liabilities. They are also businesses. Mark to market and historical price valuation of a balance sheet provide little, if any, information about the continued viability of the company's operations. Overly focusing on balance sheet values confusingly compares an institution to a closed end mutual fund.

Truthful income statements that accurately reflect revenues and expenses provide a clearer picture to the world of a company's ability to sell products at a price to cover expenses and provide a return to the owners. Income statements tell us whether a company has a successful business model. Its balance sheet does not. If businesses were only their balance sheets, every company with investors would succeed. Every restaurant would be crowded and profitable.

The long life of many financial assets is often the excuse for mark to market, but it does not change the worth and viability of a bank's ongoing business model. Currently, accounting income statements smoothed the earnings of loans and investments held to maturity. They attempt to match the future income against future losses and expenses. One problem is that an income statement can distort the view of a company's earning power if gains and losses from mark to market are included.

Modified versions of balance sheet mark to market are regulatory tools used to assess regulatory capital levels in investment banks, broker dealers, commercial banks and other financial institutions. The regulators monitor capital. The regulators can require a bank to raise more capital, which decreases the return to the previous investors, but avoids a government takeover and a complete loss to investors.

If the bank has insufficient regulatory capital, the government can close a bank even if the bank's future business model is valid and will be profitable,. The reverse is also true. A bank with a bad business plan can stay open if it has sufficient capital to satisfy the regulators.

A little over a year ago, Bear Stearns ran into funding problems. It posted collateral against its borrowings. As its collateral value diminished, Bear ran out of collateral to allow its debt to roll over. It faced a liquidity crisis. Investment banks mark to market every night. Changing mark to market methodology is not currently an investment banking industry concern and changes would not have solved Bear Stearns' collateral and liquidity problems.

Bank regulatory capital at large institutions pose two threats. Insufficient regulatory capital depresses stock prices because of the very real threat of a government takeover of the bank. It also depresses stock prices because the bank has to raise new capital and diminish the earnings available to the previous capital investors. In the current environment, mark to market has increased these threats to the continuation of the bank and to the previous investors. Naturally, these threats have caused an increase in the banking industry and in investors in the call for a change to mark to market use.

Mark to market debates are red herrings. The real issues are when should the government takeover a large troubled bank? How should the government deal with large troubled banks? Should we force them to raise new capital? Should the government invest in them, nationalize them, close them, merge them, etc? What do the regulators do about systemic risk?

Let us get off the mark to market obsession and deal with the real underlying issues affecting our banking system.