Posted by Justin Fox
The politicians in Washington, especially the Republicans in Washington, are all fired up at the moment about the scourge that is mark-to-market accounting. The bailout legislation approved by the Senate Wednesday night to be considered by the Senate tonight merely tells the SEC chairman that he has the authority to suspend mark-to-market, and commissions a study on the matter. But prominent Republicans such as Newt Gingrich and Grover Norquist have been calling on the Bush Administration to strongarm SEC Chairman Chris Cox into rescinding mark-to-market now.
For readers who haven’t been following all this, a quick recap: Mark-to-market accounting means valuing the financial instruments on a bank’s (or any company’s) balance sheet at what they would fetch on the open market today, as opposed to at their historical cost, which is the way things used to be done. It’s also often called fair-value accounting, and it’s been the law of the land–or, more accurately, the GAAP of the land–since the early 1990s, although Statement of Financial Accounting Standards No. 157, which went into effect last year, tightened up the rules a bit.
The big complaint at the moment is that markets for some mortgage-related securities have so totally broken down that marking them to market dramatically understates their value and makes banks’ finances look much shakier than they really are. The SEC and the Financial Accounting Standards Board put out a joint statement Tuesday clarifying that if the market for a particular kind of financial instrument really was dysfunctional, it would be okay to not to rely totally on current broker quotes or recent distressed sales of such instruments in determining their value. This wasn’t so much a change in policy as an attempt to point out that mark-to-market rules do allow for some amount of flexibility. “It’s mostly common sense,” Credit Suisse accounting analyst David Zion said in a report to clients Tuesday.
But what the most outspoken critics of mark-to-market seem to be calling for is a much bigger change–a move away from the direction accounting has been headed in for almost half a century. Mark-to-market had its roots in the efficient-market revolution in finance in the 1960s–whose adherents believed that the prices prevailing in the stock market and other financial markets were near-perfect reflections of economic reality. Such thinking soon prevailed in academic accounting circles as well, and the accounting professors began pushing for accounting standards that fit with their new worldview.
The savings and loan mess of the 1980s, which became such a big mess in large part because S&Ls didn’t mark their assets and liabilities to market, provided real-world impetus for such a shift. Most S&Ls became insolvent in the early 1980s because of the mismatch between the double-digit interest rates they had to pay to borrow money and the 5% to 6% a year they were earning on the 30-year-fixed mortgages that made up the bulk of their assets. But the accounting standards of the day obscured this grim reality. Some S&Ls–like Washington Mutual–took advantage of the reprieve to trim down, shape up and get themselves out of trouble. Many others became what’s known as zombie banks, lurching across the landscape running up ever bigger losses until taxpayers had to put up several hundred billion dollars to shut them down and pay off insured depositors.
So in December 1991, the FASB decreed (pdf!) that there should be fair-value accounting for financial instruments. And lo there was fair value accounting for financial instruments! While there have been lots of debates through the years over the particulars of how to implement it, the basic idea had in recent years ceased to be very controversial. The lack of fair-value accounting in Japan and the resulting scourge of zombie companies were often cited, in fact, as key causes of the country’s economic stagnation in the 1990s. (By the way, Japanese accounting authorities finally began moving toward mark-to-market last year.)
Earlier this year, though, complaints that mark-to-market was worsening the financial crisis began to surface. Blackstone’s Steve Schwarzman was among the most prominent critics. And while much of this talk was self-interested hooey (why wasn’t Schwarzman complaining about mark-to-market in 2006?), there was also an important intellectual shift at work.
The efficient market hypothesis, which had helped launch fair-value accounting, was no more–at least not in the sense it was understood and believed in the 1960s through 1990s. (Self-promotion alert! You can read all about this in my book The Myth of the Rational Market! Coming out next spring/summer! Really!) Hardly anybody believes any more that market prices are necessarily right in any fundamental sense. But most finance and accounting scholars do still believe that it’s really hard to determine a price that’s more right than the market price.
So where does that leave mark-to-market accounting? On Tuesday I let my friend Paul B.W. Miller, a prominent mark-to-market advocate, go to town on this subject. A sample:
[R]eports that are truthful are more useful than those that are not; reports based on assumptions and predictions are not as reliable as reports based on observations; mark-to-market reports are based on observations; other methods of accounting are based on assumptions or untimely measures of investments (e.g., cost); ergo, MTM accounting is superior to other forms.
But today I was talking to Gene Flood, a former Stanford finance professor who now runs the fixed-income money manager Smith Breeden Associates, and he surprised me by saying that he is no longer quite the fervent believer in mark-to-market that he once was. “The credit crisis has caused such a liquidity crunch that market prices are not a good reflection of true economic value,” he said. “If you are forced to mark everything to market, then you are not getting a good economic picture of the economic health of the institution.”
Flood doesn’t want to suspend mark-to-market accounting. He just agrees with the new FASB/SEC directions for companies to pay less heed to prices coming out of clearly distressed markets. Paul Miller doesn’t have a big problem with this guidance either.
Which leads me to the following conclusions.
First, as commenter That Anonymous Dude puts it, “MTM is the worst form of accounting, except for all those other forms that have been tried from time to time.”
Second, investors and regulators and reporters and corporate executives need to learn not to take any financial reporting numbers, whether marked-to-market or not, at face value. The health of a bank or any corporation can never be adequately measured by a single bottom-line number. Understanding the assumptions and uncertainties inherent in accounting numbers is crucial to understanding how to use them.
Third, Congress really ought to stay out of this. The last time the people on Capitol Hill seriously messed with accounting standards was with stock options in 1994. In the process they ruined America. As some guy wrote in Fortune a few years ago:
[W]hat it came down to in 1994 was that the powers that be in American economic life decided that dishonesty in the service of prosperity was no vice. In doing so, they may have paved the path for the outrages that followed. “Once CEOs demonstrated their political power to, in effect, roll the FASB and the SEC, they may have felt empowered to do a lot of other things too,” says Warren Buffett, a lonely voice in opposition to the options steamroller back then.
Fourth, if Republican opinion-makers like Gingrich and Norquist really do believe that financial market prices are so horribly wrong, maybe they need to do some reexamining of their core economic beliefs.