Are ‘Mark-to-market’ Accounting Rules on the Mark?

On April 2, the Financial Accounting Standards Board (FASB) is expected to vote on a proposal to relax an accounting standard at the heart of the financial crisis — or at least the accounting of it.

Many big banks say the crisis has been made worse — perhaps created — by mark-to-market accounting rules, which require toxic assets to be carried on their books at fire-sale prices, based on recent trades of similar assets for far less than they would command in normal times. Those bankers prefer looser accounting rules allowing higher values calculated by in-house mathematical systems.

But not everyone agrees that mark-to-market rules have been as damaging as the banks claim.

“I’ve never bought the idea that market-value accounting caused this crisis,” says Wharton accounting professor Brian J. Bushee. Changing accounting rules to accommodate the banks would be like changing the scoring system for tennis, he suggests. “It wouldn’t make you a better tennis player. Changing how we keep score — what these assets are worth — won’t change the problem…. In a sense, that’s what [the banks] are asking investors to do — to say, ‘Let’s use these four-year-old values, not what things are currently worth.'”

In March, John A. Courson, president of The Mortgage Bankers Association, told a congressional committee discussing the issue that mark-to-market rules had never been tested in an “inactive or illiquid market environment,” and that they were improperly forcing banks to report big losses due to temporary conditions. Rules should be changed to require write-downs only when conditions were judged to be permanent, he said.

If the FASB, which sets accounting rules in collaboration with the Securities and Exchange Commission, approves the rule change tomorrow, banks would be free to carry troubled assets on their books at higher prices, avoiding requirements to shore up balance sheets with new capital they cannot get now.

But potential buyers of toxic assets will make their own valuation assessments regardless of what the accounting rules allow the banks to claim, says Wharton finance professor Itay Goldstein. “After all, if assets are not marked down, investors would still fear that they are worth less” than they once were.

Mark-to-market defenders say that using market prices is the best way to derive honest values. Allowing banks too much latitude would paper over the problem, making banks look healthier than they are, they say. “It’s an issue because … the year before the crisis was the first in which firms were required to follow a new set of fair-value measurement tools,” according to Wharton accounting professor Catherine M. Schrand.

Those rules, “FAS 157,” set by the Financial Accounting Standards Board, took effect in November 2007. They were intended to clear up confusion about the circumstances under which different valuation measures could be used, and they made it harder for financial institutions to use their own systems. Under FAS 157, accounting should be based on market data, such as prices in recent sales, when it is available.

Schrand says many banks and other mortgage-market players, such as Freddie Mac, the government-authorized mortgage company, have argued that the new rules spurred a downward spiral: Listing mortgage-backed securities on financial statements at low prices discouraged buyers, making prices fall even further and leaving the market illiquid.

In fact, there are market prices for many toxic assets, even though trading has slowed substantially, she notes. But many big players argued the market was too slim to provide valid information. Says Schrand: “They didn’t like the market price so they said the market was illiquid.”

Prior to 1993, according to Schrand, assets such as mortgages and mortgage-backed securities were generally carried on bank books according to the original loan amount. A $100,000 mortgage would be booked at $100,000. A new price was substituted only after the asset was sold, and then at the sales price.

In 1993, FAS rule 115 established rules for booking such assets at market prices, which were the prices they would command if sold to investors. Financial institutions generally supported this change because many of their assets were rising in value, Bushee recalls, noting that a number of institutions now complaining about mark-to-market rules supported them in the early 1990s.

Levels I, II and III

But those were simpler times. Bundles of mortgages could be bought and sold, as they are today, but values were fairly easy to determine because they were more uniform. Some mortgage bundles were converted into mortgage-backed securities, which could be sold to investors as a type of bond. But this business was dominated by the government-authorized firms Fannie Mae and Freddie Mac, which had strict criteria for eligible mortgages. That standardization made the securities fairly easy to value.

“It was really after 1993 that a lot of tranching of the securities took place,” Schrand says. In that process, a bundle of mortgages could be sliced into a variety of securities, each slice having different features.

One might have first rights to homeowners’ monthly payments, while another would put its investors at the back of the line for payments — but pay them a higher yield for the greater risk. Yet another would entitle its owners to receive homeowners’ interest payments, while another’s owners would get the principle payments.

As private firms crowded into this business, the variety of mortgage-backed securities became mind boggling, and it became harder and harder to determine whether a mortgage-backed security that had recently sold was similar enough to another security to provide valid evidence of market prices.

FAS 157, the rule approved in 2007, set clearer rules about the use of three different accounting measures, according to Bushee. It defines “fair value” as the price that would be received to sell an asset in an orderly market. If possible, he says institutions should use the “Level One” system that relies on the most recent trades of identical assets. This is simple and uncontroversial when it comes to things like publicly traded stocks. With thousands of trades per day, there is little doubt about the current market value of Microsoft shares.

If that data is not available, the next choice is Level Two, which uses prices of similar or related securities as a guide. This might be used for a stock option — the right to buy shares of a given stock at a set price during a certain period. There may be too little trading in identical options to use Level 1 pricing, but the option’s value can be figured pretty closely by looking at prices of the stock itself.

When there is too little data for Level One or Two pricing, institutions can use Level Three. “Level Three is what people jokingly call ‘mark-to-make-believe’ or ‘mark-to-myth,'” Bushee says. It relies on calculations made by the institution itself.

In the case of a mortgage-backed security, the institution might consider factors like the default rate by homeowners whose mortgages are bundled into the security, as well as estimates of how changing economic conditions might affect default rates in the future. “Valuing these assets is all about predicting the default rate,” Bushee says, adding that “it’s just much more difficult to come up with these default rates in the current economy.”

Because firms are allowed to set up their own Level Three methodology, these systems can vary widely, and the rules require a good deal of disclosure to minimize the mystery.

In 2007 and 2008, the U.S. housing bubble burst and home prices fell in much of the country. Coupled with the recession and rising unemployment, this caused soaring numbers of homeowners to fall behind in mortgage payments and enter the foreclosure process.

As a result, the value of mortgage-backed securities that depend on the flow of homeowner payments was undermined. Because no one can confidently predict the future default level, and because many mortgage-backed securities are so highly customized and hard to evaluate, trading in these securities has slowed to a trickle. Many banks complain that the market prices that are available are misleading because they may reflect sales by banks or other investors who are willing to book enormous losses just to get these assets off their books. “There is this problem, that some institutions want to get out of these assets at whatever cost,” Bushee acknowledges.

The banks complain that FAS 157 requires Level One accounting — mark-to-market — even when the market is so limited that prices are misrepresentative. To address this, FASB recently proposed FAS 157-e, the subject of tomorrow’s vote, which establishes seven criteria for determining whether a market is not active enough to require mark-to-market accounting.

Those include situations in which there are very few recent transactions to provide pricing data, quoted prices are not based on current information, quotes vary substantially over time or between different market participants, or the difference between bid and asked prices are abnormally large. The market also would not be considered active if indexes that traditionally move in tandem with the asset no longer do, or in cases when there is very little public information, such as when most trades are private.

“Ultimately,” says Bushee, “all of these criteria require management judgment … which, of course, the banks would be happy with because it allows them to use fair-value accounting without having to depend on market prices.”

Giving banks this extra leeway can cause problems, says Schrand, noting that banks are not required to disclose all the details of their pricing systems. “To some extent, it’s a black box. If you believe that management knows more about this than you do, maybe you’d rather have them pick the portfolios [value]. But then you have the problem that they have an incentive to manipulate the model.”

The FAS 157-e proposals are generally seen as loosening the requirements to make it easier for banks to use in-house systems to keep assets on their books at higher prices. Some experts say this could undermine the government’s new programs to get toxic assets off banks’ books, since the higher prices will make the banks look healthier and give them less incentive to sell.

On the other hand, if the government’s toxic-asset purchase program does generate significant trading, the whole issue of how to value the assets remaining on banks’ books will become moot, since there will then be enough fresh data to justify mark-to-market accounting, says Wharton finance professor Franklin Allen.

Skimpy Trading

Many experts acknowledge that the skimpy trading in toxic assets creates difficulties. “If there is no trading then you can’t really mark to market,” argues Wharton finance professor Jeremy J. Siegel. “I think there’s been trading that is at too low a price…. I wouldn’t mind suspending mark-to-market for those assets right now.”

But Susan M. Wachter, professor of real estate at Wharton, thinks that for the financial and economic crises to begin to ease, the “murky” condition of banks must be clarified. That cannot be done with accounting changes that simply make the assets look more valuable, she says, arguing that the banks must instead be encouraged to get rid of those holdings. “In order for capital to come to banks, they must disgorge their non-performing assets. That mark-to-market component is necessary.”

Banks’ in-house systems cannot give accurate valuations because too many factors are unknown, such as whether the economy will deteriorate further and whether there will be additional government stimulus spending, according to Wachter.

For the banks, a chief benefit of flexible accounting is that it will make them less likely to run afoul of capital-reserve requirements, since their balance sheets will look stronger.

Siegel notes that if capital requirements are the issue, regulators could help the banks by easing those instead of changing accounting rules. Wharton finance professor Marshall E. Blume, agrees. “The regulators are in a difficult position, because these companies clearly are not as viable as they were. Having said that, you don’t change the accounting to make it look like they are viable.”

Wachter insists that capital requirements should be based on market-to-market rules, because investors who could pump capital into the banks will be reluctant to do so if they think accounting tricks make banks look healthier than they are. Easing the mark-to-market requirement, she says, “is a road to a long and sustained recession.”