Newt Gingrich points out in Forbes magazine the potentially very large role played by so-called "mark-to-market" (M2M) accounting standards in the current financial turmoil.

http://www.forbes.com/opinions/2008/...9gingrich.html

He makes a credible and persuasive argument that a very large positive impact could be made on the current situation if the M2M standard were immediately changed. He argues that such a move would relieve much of the pressure on the credit markets and mitigate most of the (perceived) need for a government "rescue".

Overview of the practical effects of mark-to-market accounting:
In effect M2M artificially lowers the value of mortgage assets on a company's balance sheet. Subsequently it appears as if the value of a company's assets is much, much lower than is actually the case. As a result, the company or bank in question incorrectly appears unable to service its debts. Apply this distorition industry-wide and all hell breaks loose.

he's right

this stuff was a recent item and huge deal when I went through my accy classwork

it's a silly rule that was created for more transparency

however, the problem is that the measurements are relatively arbitrary for what the 'market' value is in thinly traded assets
also, why mark-to-market an asset that is intended to be held-to-maturity?

post from another thread

You said in your OP that M2M artificially lowers the value of mortgage assets on a company's balance sheet, and that the result is that banks in question incorrectly appear to be unable to service their debts. How can a bank "incorrectly appear to be unable to service their debt"? You can either service your debt or you can't.

The market for these is thinly traded because NOBODY wants to buy them. Banks should not be able to count them towards their capital requirements because these securities are useless for raising capital. People who want to suspend M2M are operating under the assumption that the credit markets behind these mortgages are just temporarily failing and in gridlock, and these assets that are being valued at basically zero will be worth something one day. They are acting like in the not too distant future, everyone will be able to get credit again and be able to buy big houses like they used to, and the market will rise. Except the housing bubble and the easy credit behind those markets are not going coming back. Instead we are going to see increased foreclosures, lower prices, and inflation.

Thanks for pointing this out. It looks like I may be misunderstanding the argument about M2M here. Technically speaking I think you are clearly right here.

As I understand it M2M requires that all assets be priced "based on the last sale of similar assets". If this means that even assets which have some value are to be priced as though they don't, then I think the Gingrich argument holds to this extent.

The following is an excerpt from a letter sent by the SEC earlier this year to "certain public companies" regarding M2M:

http://www.sec.gov/divisions/corpfin...lueltr0308.htm

The emphasized phrase seems quite applicable to the current situation.

The following is from Willaim Isaac, former chair of the FDIC (1981-85):

http://online.wsj.com/article/SB122178603685354943.html

Not that his is or should be the final word, but his opinion ought to count for something.

I myself would prefer the financial market to be allowed to correct itself in this regard. But, if the financial market has already been saddled by artifice due to government interference (i.e. poorly conceived M2M standards), then the cause of the problem ought to be removed.

I haven't concluded finally that M2M standards are truly the culprit they are being claimed by many to be, but I think the argument is perhaps quite apt.

How do you decide if something has value or not?

Long story short is banks marked up the value of these securities when the boom was going on, used them as collateral to borrow more money to lend and thats why they are up **** creek now.

If you don't have mark to market then crap like Enron happens where they pretend their assets are all hunky dory while the clean up on options, bonus and everything else. When the time comes they are out 6 months ahead of everyone else and then spend a fortune avoiding jail as best they can.

Put it this way- if you didn't have M2M in place right now, would the average American even know what was going on? Would they still be plowing their retirement funds into 'blue chip' financials?

These are solid points that I fully agree with. And to the degree that mark-to-market accounting causes assets to be artificially undervalued on balance sheets, I think something needs to be done to change it.

The fact that the market for these mortgage securities is currently almost non-existent, in my opinion, should not by definition mean that their value is essentially zero. Perhaps I misunderstand how these markets work in this regard, because I'm assuming here that some measurable portion of the owners of these securities have intended to hold them on their books for no short period of time.

Didn't have time to post this yesterday:

The difference between between internal and external accounting is important here. Internal accounting are the figures a company keeps that are used by management in making decisions. External accounting is what you report to investors. It is important that external accounting is accurate and honest because it is what investors and the public use to make decisions about buying companies. These numbers have to be accurate and honest for obvious reasons. The way this works is you hire a big accounting firm, they look over your statements and give you a seal of approval which you can show to the public. Everything has to be done according to the standardized accounting rules which everyone else uses.

Internal accounting does not need to be "honest" in the same way. A company can use whatever set of accounting rules it pleases when it is keeping track of this information. If you make mistakes in your internal accounting, it is not as if you are misleading investors or the public, you are just making it impossible for your executives to run the company well.

I actually agree right now with the argument that M2M isn't valuing securities correctly. There are a lot of companies out there who are holding securities which M2M says are worth nothing, which actually have a substantial amount of value.

If you were an investor looking to potentially buy a distressed bank and were looking over its balance sheet, or an employee of a bank trying to make decisions, right now it might make sense right to change your accounting rules away from M2M. If I was looking to take over a distressed bank and was calculating what its true value was in the long run, I would not use M2M, as it would incorrectly value the asset I am trying to price I would use historical accounting for securities which there was currently no market for. So this part of your OP is actually correct in that sense: "In effect M2M artificially lowers the value of mortgage assets on a company's balance sheet. Subsequently it appears as if the value of a company's assets is much, much lower than is actually the case."

However these banks have debt payments they need to make, promises they have made, etc. Their accounting needs to reflect their current capabilities and financial position as accurately as possible. When investors look at a balance sheet, they need to know things like "The company owes X dollars on its debt at these points in time, and it has Y dollars in cash, and Z dollars in securities which they could sell for cash, etc." Right now, in one sense M2M is getting Z wrong because the market for those securities does not exist, they aren't actually worth zero. But for the present, it is exactly right because it tells you what debts a company can pay, how much it has on hand, etc.

Where moving away from M2M makes sense right now is in internal accounting. It would be absurd for a bank to evaluate itself right now according to M2M and operate under the assumptions that large parts of their balance sheets are worth zero. Running a bank is hard if you make big errors like that. The same in the case of someone trying to value and buy a bank. The huge difference is that in these situations, the people trying to peg historical values on these securities are depending on how accurate the predictions they make are. If you screw up, it is on you.

Think about it this way: I loaned a bank money a year ago and am getting repaid on Monday. Right now investors are choosing what to value and buy/sell the bank on based on its ability to repay me and others. If the bank doesn't have enough cash to pay me back and no one will lend it money (what is happening right now), then it won't be able to repay me. If its books are accurate, it will reflect that. M2M can't be "wrong" in this sense.

I have to go but it should be obvious at this point why M2M can't be suspended. Where are these historical values going to come from? They are going to be pulled out of thin air by high power accountants. Banks will get to say that they have all this money they really don't. If you think M2M is inaccurate and want to use what you think is a better set of rules for your decisions, by all means do so. In that case you bear the burden of the accuracy of your accountants' guesses. But you can't go around telling other people that this is what you are actually worth.

In the long wrong, the worst effects of suspending M2M wouldn't be fraud. It would be that people would start simply ignoring the financial statements of lots of companies. Investors looking at a balance sheet containing the "historical values" of a group of MBSs will just say "These numbers do not reflect reality and aren't useful to me". There would be worse information for market participants to make decisions, which is obviously bad, but worse, the companies that were publishing accurate information would be penalized.

Awesome reply thanks. I quoted the above part of it because time horizons seem to be important to the "suspend M2M now" arguments.

It seems that in terms of external accounting, the standard for determining the solvency of any given financial institution is that WERE ALL OF ITS OBLIGATIONS DUE TO BE REPAID TODAY, could it meet these obligations or not?

I appreciate the need to hold to such a standard. However this external accounting standard seems NOT to be a true reflection of what is actually going to happen today. What is going to happen today is that only some small portion of an institution's obligations will need to be repaid.

My problem with M2M is that by requiring valuable assets to in effect be assigned a book value of almost zero, the external accounting standard of how to determine solvency becomes a self-fulfilling prophecy.

In other words, the only reason any financial institution may on any given day ACTUALLY face the prospect of having to service all of its obligations is due directly to the distorting effects of M2M. The institution is now insolvent and has to be liquidated to pay back creditors.

I've read a few arguments that if M2M is suspended that a double-standard would be created because financial institutions were able, under M2M, to overvalue their assets when everything was going well.

If this is true, then it seems M2M isn't a perfect method because it distorts the true average value of assets: to the high side during market expansion and to the low side during contraction. But perhaps it is nevertheless the best available standard. However, this does raise a couple of questions:

How can markets be efficient when the book value of financial assets don't reflect their true worth?

Is the use of M2M, with its apparent distorting effects upon true asset values, causing the financial markets to overcorrect?

I would like to say this, sometimes very efficient correct valuations can look way out of wack. Consider this scenario.

Country Holding Equity Assesment Team (CHEAT) has a lot of CDOs and are running into liquidity issues. They need to sell off some assets to recover their reserves. The Big Unified Financial Futures Evaluation Team (BUFFET) comes in and asses what is for sale to see if they want to buy. BUFFET is a big company so instead of buying individual securities they offer to either loan a large sum of money, or purchase a large amount of stock (or some combination). So you can view BUFFET's offer as a proxy for the overall health of the company.

On the other hand CHEAT may try to sell its assets on the open market, to General Optimistic Equity (GOE). Now CHEAT isn't selling all of its company, its specifically choosing which assets to sell. You can view these assets in two ways, either CHEAT doesn't know how to evaluate which securities are the best and which are the worst then you would value each one on the market at some average point. The other way is to assume CHEAT can tell (to some degree) the difference between its securities. CHEAT has to look to two things, solving its liquidity problems now doesn't do a whole lot of good if they end up with their worst securities only since their future revenue streams will be largely determined by the securities they keep. Why work your butt off to stay solvent for a few years if inevitably you go bust. So Cheat trying to keep its best securities and sell its worst for as much as possible sounds like the most likely plan they will follow.

If you take the second view of the situation and say that the $0.22 that are being offered for each $1 in securities on sale (which is about what the cheapest that have actually been traded are going for) represents NOT an average of those securities, but a selected bundle of the worst securities that these companies have, then the prices start to make a lot of sense.