Mark-to-Market Rules - Worsening the Credit Crisis?
Many question whether this deluge of losses is actually necessary. Bankers are pressuring regulators and lawmakers to make adjustments to FAS 157, the mark-to-market accounting rule in the US. Put in place in response to the Enron crisis (Enron overvalued its assets to the point of bankruptcy) mark-to-market accounting requires corporations to value assets at their "fair value"; the price the asset would command on the open market.
For example, say the 100 shares of stock that I purchased for $25 two months ago are now worth $35 (unlikely in these current market conditions, but bear with me). The corresponding mark-to-market value of the shares would be $3500. Under FAS 157, my personal balance sheet must value the stock at $3500. Or a more realistic example would be – I live in a home, pay a mortgage determined by the purchase value and the loan that I originally availed to finance the home; now the value of the home has fallen, should the bank call me to post more collateral to compensate for my loan-to-value increase, even though I have been regular in paying my monthly mortgage?
Despite the fact that the majority of MBS owned by banks are not in default, the fair market value for them is very low. Why? The market is illiquid, no one is buying them. The spread between the bid and the ask is too large—and mark-to-market values assets based on the bid.
Normally, it would be fair for banks to value securities at the price they are fetching on the open market. But these aren’t normal times, and most Banks argue that the value of the securities they are holding is actually much higher than their current market value. Meanwhile, the value of bank balance sheets are plummeting—forcing them to write-down losses and seek outside funds to maintain required capital ratios. European regulators suspended mark-to-market accounting in early October, 2008.
Proponents of mark-to-market accounting argue that the rule helps prevent banks from understating the gravity of their situations. Investors and creditors have the right to know the true value of publicly-traded companies. Says Dane Mott, Analyst with JPMorgan Chase: "Blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick."
This is a great analogy, but to what extent should you believe the doctor? In the current situation it could be said that using mark-to-market accounting on mortgage backed securities is like the doctor telling you that you have brain cancer when in fact you are just suffering from stress-related headaches. I am keen to hear your views!