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Interesting take on "market to market accounting"

By
Education & Training with Independent Leadership & Financial Fitness Consultant

Throughout this banking crisis I've been hearing financial pundits use the term - "market to market" accounting.  I figured that it attempted to help financial institutions or businesses understand what their true market value was on paper.  However until today, I never really dove into what the actual definition is really.

So here it is;

 

Mark-to-market is an accounting methodology of assigning a value to a position held in a financial instrument based on the current market price for the instrument or similar instruments. For example, the final value of a futures contract that expires in 9 months will not be known until it expires. If it is marked to market, for accounting purposes it is assigned the value that it would currently fetch in the open market.

 

So basically, if you buy 1000 shares of GE, and you purchase them at $22.00 and the stock goes up to $30.00 a share, then your 1000 shares are valued at $30,000.  If on the other hand you buy at $22.00 and the stock falls to $10.00, then they are worth $10,000.  Easy enough to understand, but the devil is in the details.

Now in the stock market you have options, futures, short positions, long positions, margin calls, etc.  You also have computer traders who bet on options throughout the day, they'll pour millions into positions that they are in and out the same day.  This of course can exacerbate margin calls or short calls when a stock is being pushed downward, example recently has been Merril Lynch and Lehman brothers. The problem is that these values are only determined at the end of the day, and often financial institutions are forced to buttress their stocks position during the trading day, often forcing these companies or investors to cover huge margin positions.  It's a wonder that this whole system hasn't already collapsed with hedge funds, derivatives, and the myriad other Wall Street investment strategies or rules.

The problem is that there is a special accounting rule called, FAS 157, and it requires banks to assign fair value or a "market-to-market" value to these mortgage backed assets.  The problem is that to have value they need to be trading, and if they are not trading then a fair market value cannot be attached to the asset.  For example, Lehman brothers has 100 Billion dollars in packaged mortgage backed debt that they are servicing.  7% of the debt is in foreclosure or default, but Lehman is not the only institution with this problem.  Banks across the country are having similar problems with their mortgage loans as well.  At this point their is a perception that mortgage backed securities are dangerous.  This has a vicious circle effect with all the players in the market and soon no one is purchasing any debt from anyone else.  Despite the fact that 93% of the mortgage debt is performing!!  Meanwhile, the market value of these companies cannot be determined, and then traders begin bidding down the value of these companies, which forces the companies to dilute their stock further by raising more capital.

Interesting article I read today though suggests that "market-to-market" may have in fact saved our bacon.  Read this article called, "New Life".

Basically he's suggesting that this actually could work out for us in the long run. Instead of a long drawn out decline, this may have pushed us to basement allot faster, which will allow us to recover allot faster as well.  We can only hope he's correct.

Look, if you still don't understand "market-to-market value" then don't feel bad.  Allot of people don't understand how 93% of borrowers can be performing on this mortgage payments, but the bank is taking a beating in the market.  Something just doesn't seem right, but perhaps the problem is much bigger, and market-to-market is like a forest fire that is quickly burning up the dead wood.

 

Posted by

James Engel
Keller Williams Realty Beverly Hills - Beverly Hills, CA
KW Beverly Hills

Mark to market is what banks asess position risk for traders and make margin calls accordingly. In a real estate market mark to market would bankrupt 90% of consumers and equal amount of banks. Sometimes you just need an uncle to step in and cosign for credibility and so far Uncle Sam is living upto its job description.

Oct 13, 2008 04:26 AM
Richard Sweum
1st Security Bank - Everett, WA

Mark to Market prevents the Ponzi cycle from continuing...sorry, I'm not a fan Voodoo accounting.

Oct 13, 2008 05:04 AM
K C
Independent Leadership & Financial Fitness Consultant - Pleasant Grove, UT

James....I think your hitting the concern that most banks are putting out there right now, but markt to market does make sense in terms of what the real value of an asset is at the moment.  The question really come down to the trading rules that the SEC and congress allow on Wall Street. 

Rich....I agree with you, but it does make you stratch your head and wonder why market-to-market is the reason why these real estate asset's have no value.  I know that the market always determines what value is at the moment, but when you have Panic like you've seen the last two week, how can you asses value at that moment.  The lot, the cost to build the home are actually relevant in terms of value.  This week the house may not have "percieved value", but next week it could be actually only 10% of what it's value was a month ago.  So why should the bank lose it's complete value over an asset that is temporarily unvalued.  I think there needs to be some serious effort of reforming "market-to-market", I do agree that it makes better sense then previous "voodoo" accounting methods, but there needs to be some effort to tweek the system.

Oct 13, 2008 05:43 AM
Richard Sweum
1st Security Bank - Everett, WA

Hi Karl, if you take ALL of the other mechanisms employed by Financials, CDS's, off-balance sheet accounting, CINA (capitalization income from negative amortization) etc, etc; it would be like allowing the meth addict to continue to snort coke...they continue their dysfunction ad nauseum.  I'm done with "Enron Accounting,"  we deal with the cancer and quite treating the symptoms, or we are never going to get rid of the cancer.

Oct 13, 2008 08:13 AM
Anonymous
Jeff

Karl - Interesting post.  Simply put, Mark-to-Market means, forget about what you paid for an asset or position - Mark its value on your books today, to reflect its current Market value.

It's causing huge, unrealized "paper" accounting losses for banks (because they haven't actually sold, or otherwise realized an "actual" loss, since most of the assets are performing just fine), which reduces their capital, which in turn, restricts their ability to lend.

As for the financial pundits you heard incorrectly call it, "Market to Market" - I'd lose them in a hurry, unless they could have actually been saying, "Mark it to Market"

Oct 13, 2008 09:28 PM
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