Mark-to-Market
| Mark-to-market is a subset of fair value accounting. Fair value accounting refers to valuing assets and liabilities on the balance sheet at fair or market value. Mark-to-market is used interchangeably with fair value accounting, though technically it means bringing gains and losses of certain financial instruments onto the income statement. |
Mark-to-Market Accounting and the Financial Crisis
A spotlight shined on mark-to-market accounting as the financial storm was growing and its headwinds were felt by the world economy, investment banks, insurance firms, and traditional lending banks. Financial institutions argued that mark-to-market accounting exacerbated the financial crisis by forcing holders of distressed assets such as mortgage backed securities to report items far below what they would receive in a normal market.
Banks in particular argued that writing down mortgage backed securities (MBS) and related assets put undo stress on their capital requirements, and contributed to the freezing credit markets and the overall credit crisis.
For example, when a bank must write down $100 billion in assets in mark-to-market accounting, then it removes $1 trillion in lending capacity when the bank is allowed to lend ten times their capital per regulatory requirements.
Investors have noted that the real cause of the credit crisis was not mark-to-market accounting, but highly leveraged banks, fraudulent lending, lax loan requirements, and the creation of highly risky financial instruments such as derivatives and MBS where loans were securitized and sold instead of held by the bank. There were $1.2 trillion sub-prime mortgages that were securitized and sold, about $200 – $300 billion held by FDIC insured banks, and the rest sold to the world.
Banks traditionally held loans to maturity, so lending requirements were much stricter resulting in loans of higher quality. It was in the bank’s best interest to seek high quality borrowers to maximize returns and minimize bad debts and defaults since loans were held on the books for years and even decades.
Securitization allowed banks to sell loans worldwide, thus reducing lending standards since they no longer held the loans on their own balance sheet until maturity, while creating a profitable source of loan fees and bonuses based on loan volume instead of loan quality. Mark-to-market accounting only reflected rapidly declining loan values of mortgage – backed securities due to increasingly lax lending standards made possible by selling the securities worldwide.
Blaming fair value accounting, some argued, is similar to shooting the messenger after reckless lending practices came home to roost in the form of deteriorating economic conditions of financial institutions.
Nevertheless, clarification of mark-to-market accounting was in order during market turmoil, and the SEC and Congress recommended that FASB clarify fair value accounting and specifically mark-to-market accounting (taken to earnings). In 2008 the SEC and FASB issued clarification of FAS 157 where market values in a disorderly market were not determinative when measuring fair value, and that distressed and forced liquidation sales are not orderly transactions.
| Under pressure from Congress, on April 2, 2009 FASB voted to suspend mark-to-market rules for bank assets. The ruling allows banks to ignore market prices for assets if they determine that the market is illiquid and that the most recent sales are by distressed sellers at fire-sale prices. This also increased the banks lending capacity based on newly stated capital that is no longer based on mark-to-market accounting. |
This essentially means that banks do not need to report actual losses that they are incurring from bad mortgages under pressure from Congress.
Fair Value Accounting
FASB released FAS No 157 effective in November of 2007 just as the financial crisis was bearing down on financial markets. FAS 157 further defined how to value financial instruments. However, FASB had been moving to fair value accounting as early as the 70’s. Although U.S. standards had stressed historical cost, the partial merge into fair value accounting created a mixed accounting model that emphasized historical cost for some assets and fair value accounting for others. For example, prior accounting standards relating to fair value include:
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FAS 157 did not add any new items requiring fair value reporting, nor does it change which assets are reported at fair value. FAS 157 clarified previous provisions that were scattered in different statements in GAAP to provide consistency and comparability for fair value accounting reporting methods. In essence, FAS 157 clarified fair value reporting under one summary statement in order to apply fair value accounting consistently.
The controversy surrounding FAS 157 , however, was that it was released just when financial markets faced enormous downward market pressure due to the housing crisis.
FAS 157 defines fair value as the price to sell an asset or transfer a liability in an orderly transaction between market participants at the measurement date.
FAS 157 establishes a hierarchy of inputs to value financial instruments:
- Level 1 which have available quoted prices of those instruments;
- Level 2 which do not have quoted prices available but have quoted prices from similar financial instruments, or quoted prices for similar assets in markets that are not active, and
- Level 3 inputs which do not have observable prices but instead require judgments and modeling to estimate the fair value price (i.e. mark-to-model).
Level 1 inputs have the highest priority and are considered the most reliable, while level 3 inputs have the lowest priority.
In the case of highly illiquid markets where level 1 inputs are no longer available, level 2 inputs may be driven by forced sales, in which case FAS 157 allows companies to use level 3 model-based fair values. However, in order to do this, firms must show that transactions are not orderly and that sales are driven by forced sales in illiquid markets under level 2. If they cannot show this, then firms must use level 2 fair values which can lead to substantial unrealized losses.
However, as previously mentioned, Congress pressured FASB to suspend mark-to-market rules for bank assets due to massive losses they would incur from mortgage-backed securities.
From Mark-to-Market to Historical Cost Accounting
GAAP
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