Mark to Market Accounting, How It Works, and Its Pros and Cons
How an Accounting Method Might Have Caused the Great Recession
Mark to market is an accounting method that values an asset to its current market level. It shows how much a company would receive if it sold the asset today. For that reason, it's also called fair value accounting or market value accounting. It's similar to the replacement value in your insurance policy.
The alternative method is called historical cost accounting. It keeps the asset's value on the books at its original level. It's like insuring the depreciated value of your car.
How It Works
At the end of each fiscal year, a company must report how much each asset is worth in its financial statements. It's easy for accountants to estimate the market value if traders buy and sell that type of asset often.
A good example is the 10-year Treasury note. The accountant reprices the asset according to the quoted rate in the market. If the Treasury yield rate rose during the year, the accountant must mark down the value of the notes. The note that the bank holds doesn't pay as much in interest as new notes. If the company sold the bond, it would receive less than it paid for it. The values of Treasury notes are published in the financial press every business day.
Marking to market is harder for an asset that's not liquid. The controller must estimate what the value would be if the asset could be sold. An example is a home mortgage. The accountant must determine what that mortgage would be worth if the company sold it to another bank. It depends on how likely the borrower would make all the payments.
To estimate the value of illiquid assets, the controller can choose from two other methods. The first is called the default risk method. It incorporates the probability that the asset isn't worth its original value. For the home mortgage, the accountant would look at the borrower's credit score. If the score is low, there's a higher chance the mortgage won't be repaid. The accountant would discount the original value by the percent risk that the borrower will default.
The second method is called interest-rate risk. It incorporates the value of the assets compared to similar assets. For example, say the asset is a bond. If interest rates rise, then the bond must be marked down. That's because potential buyers would pay less for a bond that offers a lower return. But there is not a liquid market for this bond like there is for Treasury notes. As a result, the accountant would start with the bond's value based on Treasury notes. He or she would reduce the bond's value, based on its risk as determined by a Standard and Poor's credit rating.
Pros and Cons
Mark to market gives an accurate picture of an asset's current value. Investors need to know if a company's assets declined in value. Otherwise, the company may overvalue its true net worth.
For example, mark to market accounting could have prevented the Savings and Loan Crisis. In the 1970s and 1980s, banks used historical accounting. They listed the original price of real estate they bought. They only updated this price when they sold the asset.
When oil prices dropped in 1986, the property held by Texas savings and loans also fell. But the banks kept the value on their books at the original price. That made it seem the banks were in better financial shape than they were. Banks hid the deteriorating state of their declining assets.
Mark to market is dangerous when the economy is crashing. As all asset values decline, companies suddenly lose their net worth. As a result, many businesses would go bankrupt. It would set off a downward spiral that would only make a recession worse.
For example, mark to market accounting worsened the Great Depression. The Federal Reserve noted that mark to market was responsible for many bank failures. Many banks were forced out of business after they devalued their assets. In 1938, President Roosevelt took the Fed's advice and repealed it.
Role in the 2008 Financial Crisis
Mark to market accounting may have worsened the 2008 financial crisis. First, banks raised the value of their mortgage-backed securities as housing costs skyrocketed. They then scrambled to increase the number of loans they made to maintain the balance between assets and liabilities. In their desperation to sell more mortgages, they eased up on credit requirements. As a result, they loaded up on subprime mortgages. That was one of the ways derivatives caused the mortgage crisis.
The second problem occurred when asset prices started falling. Mark to market accounting forced banks to write down the value of their subprime securities. Now banks needed to lend less to make sure their liabilities weren't greater than their assets. Mark to market inflated the housing bubble and deflated home values during the decline.
In 2009, the U.S. Financial Accounting Standards Board eased the mark to market accounting rule. This suspension allowed banks to keep the value of the MBS on their books. In reality, the values had plummeted.
If the banks were forced to mark their value down, it would have triggered the default clauses of their derivatives contracts. The contracts required coverage from credit default swaps insurance when the MBS value reached a certain level. It would have wiped out all the largest banking institutions in the world.
How It Affects You
Mark to market discipline can help you manage your finances. You should review your retirement portfolio each month to record its current value.
Once or twice a year you should meet with your financial adviser to rebalance your holdings. Make sure they are aligned with your desired asset allocation. That's necessary to maintain the benefits of a diversified portfolio.