Mark to Market--the Middle Ground

In its current cover story, “Let it Flow”, Barrons provides some insights into the middle ground on mark to market accounting.

"Ending the credit crisis will be highly unlikely without some type of accounting accommodation," according to Bridgewater Associates, the highly respected institutional money manager. "Because mark-to-market accounting on existing assets threatens bank capital today, it increases solvency concerns today, which raises funding costs and accelerates the need to sell assets today, which depresses the prices of those assets, which threatens capital and raises funding costs.

This cycle can be broken if banks communicated an accurate or conservative assessment of the fair value of their assets in the footnotes of their financial statements, thereby telling equity and bond investors what they need to know to value the company. But if these losses were accrued over the remaining life of the assets, thereby avoiding the immediate hit to the book value of capital, the selling pressure would be reduced, which might even allow prices to rise and reverse the cycle and improve sentiment. This seems pretty obvious without any knowledge of history, but history overwhelmingly confirms the need for such a change."

Bridgewater's proposal isn't the same as more radical suggestions to suspend so-called fair-value accounting. Indeed, ignoring current market values of assets would only heighten the lack of faith investors display for current book values.

"Many of the current requirements stem from the Savings & Loan crisis in the 1980s, when we learned that not knowing the real, current values of financial instruments held by financial institutions can be devastating when the bubble finally bursts and institutions are forced to close their doors," executives at the Center for Audit Quality wrote in a letter to the heads of the Fed, Treasury and SEC, urging them not to back off from mark-to-market standards.

But there should be a middle ground between simply accepting a historical cost and forcing assets that are not in default to be written down to current prices, notably those based on indexes of credit derivatives that frequently diverge from the prices of the actual underlying assets.

Last week, the SEC and the Financial Accounting Standards Board attempted to forge such a via media, or middle way. When no active market for a security exists, management may estimate values from market expectations of future cash flows and an appropriate risk premium, they wrote in a release. In other words, assets don't have to be valued based on current low-ball bids in a dysfunctional market. But the assets do have to reflect reasonable expectations of their payoff and risks, to satisfy investors and auditors. Does Arthur Andersen ring a bell?

THE KEY REASON TO limit mark-to-market losses is to preserve capital, whose conservation is the main constraint on the financial system.