What’s Wrong With Mark-to-Market?

There has been a huge controversy among economists, politicians, regulators, and bankers on how to deal with bank assets that have lost value. There is a FASB rule (Statement 157) that requires public companies (i. e., banks) to value some of their capital assets on their balance sheets at fair market value. This is the mark-to-market (MTM) rule. Banks want to change the rule to allow them to value these assets at what they think the values should be (Statement 115).

This is important to banks because it determines the amount of capital they have in relation to their ability to lend a multiple of that amount. Because of fractional reserve banking, a bank can lend up to 10X or 20X or even 50X the amount of their capital base, depending on who’s looking.

Many banks bought subprime securities which became a part of their capital base. Their values have collapsed and banks are complaining that MTM unfairly requires them to value these assets at fire sale prices. If they don’t have to carry them at cost their balance sheets would still look good, they wouldn’t have to come up with additional capital, and their ability to lend wouldn’t shrink.

The controversy has been that this rule has helped cause our financial crisis. When credit supposedly has dried up, the MTM rule compounds the problem the critics say. It is pro-cyclical because it magnifies financial problems by requiring them to value these assets at prices that are too low, thus impairing their ability to make loans. According to Brian Wesbury of First Trust Advisors in Chicago, it’s as if a house is burning down in your neighborhood and your lender says because of that fire your house’s value is now diminished and they require more equity to support your existing loan.

Not a very good analogy. Better: you started a slow fire in your brand new McMansion and finally it caught the drapes and your house in burned in the conflagration. Then you whine about it.

It’s interesting that many on the right have rallied around this issue. Their argument is that the government has implemented another stupid regulation without understanding the consequences and now it has hurt the banks and turned the crash into a financial disaster. If only the SEC would suspend the rule everything would be OK.

Everyone knows that it’s a good financial practice for lenders to properly value their assets. Otherwise how would you know if your deposits are safe at any bank? Now, I certainly don’t question the government’s role in causing this crisis (see, Law of Unintended Consequences). But let’s examine the MTM rule. It was adopted by the SEC because it was adopted and recommended by the Financial Accounting Standards Board (FASB), a private association of financial accountants and industry people who self-regulate accounting standards. So, even if the SEC didn’t adopt this rule, companies would have had to adhere to the MTM rule. If they didn’t no one would lend them money.

In an article by Nicole Galinas of the Manhattan Institute, MTM isn’t something new. And companies only have to MTM those securities that are held for short-term investment or derivatives like subprime based securities. If securities are going to be held to maturity, they don’t have to MTM unless they believe that it is “permanently impaired.” Even then, they must only mark down values of the bad mortgages.

I therefore don’t see anything wrong with MTM.

Why should MTM be suspended in times of financial crisis? This is precisely the time when we should demand that banks should MTM.

Banks for years have been making bad financial decisions and now they want to paper it over as if they shouldn’t pay the penalty for their mistakes. Bruce Wasserstein of Lazard says says, “Accounting has now become an exercise in creative fiction,” he said. “Saying assets are worth a lot doesn’t make them worth a lot.” The problem is not MTM but bad decisions. And they know this. If you had bought a subprime security with money borrowed from them, I can assure you that they would require you to MTM and pay down the loan.

Let’s face it: they bought risky securities that aren’t worth what they paid for them. They then used their inflated balance sheets to lend far more than the underlying economic reality of their asset base should have allowed. This only added to the instability of the economy. If we let them avoid MTM now, then more instability will result because now we know they have over-leveraged their capital base.

There is a reason that we need to allow this debt to fall to its true value. Until all the bad assets of the boom years are properly valued (i.e., reduced to fair market value) the crisis will continue because no one will trust bank balance sheets. By propping up banks with phony values, the government will only create continued instability in the financial system. Instead of “pro-cyclical” revaluation being bad, it is actually good for the economy. The sooner it happens, the sooner we will be out of this recession/depression. This is nothing but a bailout of banks for making bad decisions. The interference of the government in this revaluation of bank capital is one of the things Japan tried. They turned their crash into a 15 year nightmare.

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9 comments to What’s Wrong With Mark-to-Market?

  • Anonymous

    I was prepared to be angry because your title suggested you were going to defend those who oppose MTM.

    Well done, your description of why MTM is a critical element of making the market work seems right on.

    Imagine a situation when bankers know their real worth, but prospective buyers of the bank’s equity do not, or if a mutual fund were simply to say “here’s what we paid for it so many years ago, you assume we’re ok.”

    Excellent piece.


  • Anonymous

    Econophile you are “right on the mark”. Now, that the individuals who ran and/or continue to run our financial institutions refuse to fess-up to their responsibility for investing in weak assets and multiples of cash to value formulas that only drunken or insane CEO’s would approve, they want to readjust the “rules” of the game! Unbelievable! Have these folks no shame as Joseph Welsh said to Joe McCarthy a few years ago!

  • [...] There is a FASB rule (Statement 157) that requires public companies (i. e., banks ) to value some of their capital assets on their balance sheets at fair market value. This is the mark-to-market (MTM) rule. Banks want to change the rule …[Continue Reading] [...]

  • Joe

    The laws of the market are not objective like the laws of physics. Rather, they are a negotiation, like the laws governing divorce. In order to mark a security to market you need a few strong, profit-motivated, fully informed counterparties. If one side is desperate, they won’t agree on a fair price, just like in a divorce. Much of the crazy spread and price levels observed at Dec 2008 reflect panic selling. To require institutions to abandon any judgment about prospective performance in setting marks under conditions like that is insane. Some of these new rules like FASB’s new financial instruments draft may make it easier for a mindless auditor but are suicidal for the financial system as a whole.The whole uncompromising and selfrighteous tone f the debate is a sad comment on the on our ability to comprehend, much less do, the right thing.

    • And, if there are no buyers? Banks have to mark them down. Otherwise they are concealing the fact that they are in far worse financial shape than their financials reveal and that is misleading to investors and serves to tie up capital in failed projects. This is our major problem right now: credit crunch. Information is never perfect and parties are never fully informed, ever. This is the major flaw in Modern Portfolio Theory. It’s a big fiction. Thanks for your comment.

    • Buck


      The bank siezures occuring now 2 years after the ‘panic selling’ you describe routinely unmask asset overvaluation (i.e. fraud) running 20-50%. Its all there in black and white on the FDIC website every friday.

      Assuming the Too Big To Fail’s are over-valuing their listed 7.5T of assets at the lower end of what the FDIC is finding ‘in the field’ on a weekly basis, you can safely estimate nearly 2T of losses as yet unrealized, courtesy of 157 suspension.

      Check out some of William Black’s thoughts on this. He does a great job of explaining the issues, especially the moral hazard historical contrasts to the S&L debacle.

  • Charles

    The key point is that the banks got to choose up front: hold to maturity or hold to trade for each asset. hold to maturity means no MTM unless permanently impaired. hold to trade means MTM. Now the real question is why did the banks choose to put so many assets as hold to trade? The answer is this: hold to maturity requires banks to keep reserves to cover the asset whereas hold to trade requires *NO* reserves. This enabled banks to lever up to generate higher (false) profits!

  • JC

    First, the stock market is not a mark to market vehicle, as most might think. For example, the last trade for Hewlett Packard at 9X earnings does not make the world’s accountants mark down every stock in the market and in every portfolio to 9X earnings. Mark to market is an artificial construct based on a closed market. In 2008, I was desparate to buy some of these marked to market mortgages but could not access the market. Try it. Go to E-Trade, Charles Schwab, your local bank. No one knows how you can buy them, unless you show up in New York with about $100 million.

    I was a bank appraiser for over 14 years with many appraisers reporting to me. When the market crashes, there are NO buyers in a mark to market environment, unless they are non-regulated entities with tons of cash. Performing loans are sold at the behest of regulators, who say that “you need to get your real estate exposure down to X% of your portfolio’ or something similar. In 2008, margin calls at Merrill and Bear exacerbated the pricing on the down side. If you think it was a great idea to have banks take 70% write offs on performing loans, and that this will not have an impact on the banking system (govt. takeover, bailouts), or that the fear of making loans will not last, then you are a mark to market lover. Mark to market accounting does not mark loans to market value. But it is definitely pro-cyclical on the downside. My experience also tells me that the govt. will not allow mark ups until the market is extremely overheated and “there is no reason to be overly conservative.”

    • I am a MTM lover. Banks’ balance sheets are a fraud because they are less solvent than they report because they have not properly reflected the risk of their CRE loan portfolios. Extend and pretend, delay and pray do nothing to help banks or the economy. This is the main reason why we have a credit crunch now. There is nothing “pro-cyclical” about MTM. Rather it is a reflection of the reality that these loans are underwater. Bankers made the assumption that this was just another cycle and that we’d pull out of it quickly. That has proven to be very poor judgement and is just an attempt to paper over what is really happening. Because of they aren’t lending, I don’t know why people can’t see that we already have had a serious impact on the banking system. Avoid MTM and things will get worse.