Mark to Market Accounting: How It Works
Use This Little-Known Trick to Beat Both Inflation and Recessions
Definition: Mark to market is when a company updates the value of an asset to its current market levels. For that reason, it's also called fair value accounting or market value accounting. The alternative method is called historical cost accounting. It keeps the asset's value on the books at its original level.
How It Works
At the end of each fiscal year, businesses must estimate how much the asset is worth.
That's easy if traders buy and sell that type of asset often. A good example is the 10-year Treasury note. The accountant just reprices the asset according to the going rate in the market.
Marking to market is harder for an asset that's not as liquid. 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 it's value on the books. For example, there's always a chance a borrower won't repay a loan. If the borrower has only paid back half of what is due, the accountant would discount the bond by 50%.
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. (Source: "Making Sense of Mark to Market," Federal Reserve Bank of St.
Louis, January 1994.)
Did It Cause the Great Depression?
Mark to market accounting was the law of the land until 1938. President Roosevelt took the advice of the Federal Reserve and repealed it. The Fed noted that mark to market was responsible for many bank failures. Many banks were forced out of business after they devalued their assets during the Great Depression.
(Source: "A Mark to Market History Lesson," FTAlphaville, March 13, 2009.)
It Could Have Prevented the Savings and Loan Crisis
In the 1970s and 1980s, many banks used historical accounting. They listed the original price of real estate they bought. They updated this price when they sold the asset. Companies that did this could sell an asset that had dramatically risen in price if they needed extra cash.
Historical accounting helped cause the Savings and Loan Crisis. 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 the their declining assets.
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 made to maintain the balance between assets and liabilities. That's just one of the reasons banks loaded up on subprime mortgages. For other reasons, see How 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. Banks lent less to make sure their liabilities weren't greater than their assets. For this reason, many blame mark to market accounting for increasing euphoria during a market bubble. They also point out it hastened the economy's decline. (Source: "True Impact of Mark-to-market Accounting in the Credit Crisis," FT.com, February 29, 2008)
In 2009, the US Financial Accounting Standards Board (FASB) 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. That would have wiped out all the largest banking institutions in the world. (Source: Ron Hera, "Forget About Housing, The Real Real Cause of the Crisis Was OTC Derivatives," Business Insider, May 11, 2010)
How It Affects You
Mark to market discipline can help you manage your personal 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.