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What is “Mark to Market” and Why Should We Care?

There is a provision in the $700 billion bailout bill that allows the Securities and Exchange Commission (SEC) to suspend “Mark to Market” valuation of assets.  The adoption of this accounting standard was in response to the Enron and many other accounting scandals that occurred around the same time.  If SEC does suspend this standard, will we go back to Enron type disclosures of complex financial instruments?

Section 132 of the U.S. Senate’s version of the “Emergency Economic Stabilization Act of 2008” there is the following language:

SEC. 132. AUTHORITY TO SUSPEND MARK-TO-MARKET ACCOUNTING.

(a) AUTHORITY.—The Securities and Exchange Commission shall have the authority under the securities laws (as such term is defined in section 3(a)(47) of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(47)) to suspend, by rule, regulation, or order, the application of Statement Number 157 of the Financial Accounting Standards Board for any issuer (as such term is defined in section 3(a)(8) of such Act) or with respect to any class or category of transaction if the Commission determines that is necessary or appropriate in the public interest and is consistent with the protection of investors.

This one paragraph in a 451 page bill can impact the integrity of the information given to the public by publicly traded financial institutions.  These are the same financial institutions that are at the center of this financial crisis.  We need more transparency and clarity of the financial conditions of these companies not less.

This story begins with the fall of Enron.  On December 2, 2001, Enron filed for the largest bankruptcy case in U.S. history – over $32 billion of debt.  Enron was involved in highly questionable accounting schemes that hide debt obligations and overvalued assets.

In response to Enron, and several other accounting scandals, Congress passed the Public Company Accounting Reform and Investor Protection Act of 2002 also known as Sarbanes-Oxley Act of 2002 and President Bush signed it into law.  This legislation established new standards for all publicly traded U.S. companies including the company boards, management and public accounting firms.  It authorized the SEC to establish new accounting standards.

The SEC, working with the Financial Accounting Standards Board (FASB), adopted what is known as Statement No. 157 – Fair Value Measurements.  Statement No. 157 established the accounting standard “mark to market” for publicly traded companies.  “Mark to Market” is an accounting method that values assets and financial instruments according to the current market price for that asset or financial instrument.

Prior to Statement No. 157 there were different definitions of fair value and that is where companies like Enron took advantage of the lack of clarity in the accounting rules or standards.  Companies like Enron essentially created their own definitions of fair value that obviously masked the riskiness of their assets and financial instruments; and in most cases overvalued those assets and financial instruments.  But what the investing public saw from these companies’ audited financial statements was all good.

Statement No. 157 provided guidance and one standard for valuing assets and financial instruments.  The goal of this standard was to provide a clearer understanding of how a publicly traded company valued assets and financial instruments particularly complex ones.  A transparent and accurate valuation is the basis for the reflection of the value of a company through its stock price.  Bad or inaccurate asset or financial instrument valuations result in inaccurate stock prices – like in the case of Enron.

The financial crisis brings new challenges to this accounting standard.  The problem publicly traded financial institutions, such banks, insurance companies and investment banks, are having is that many of their assets related to the subprime mortgage fiasco are either illiquid (can’t trade) or worth very little.  This means that the companies’ accountants can’t determine the market value of these toxic assets and financial instruments or if the accountants do valuate them according to “mark to market” it gives a very bad result.  The financial institutions are crying to the SEC and friends in congress about their problem.

Their friends are responding.  SEC issued a clarification on September 30, 2008 that give management more flexibility in valuating the toxic assets and financial instruments.  Some people like Newt Gingrich are bloviating about how “mark to market” created this crisis.  Then in an effort to garner more votes for the $700 billion bailout bill the Senate leadership included Section 132 (stated above).  It is not clear whether SEC will suspend Statement 157 and “mark to market” valuations.

So there you have it – the SEC can waive it’s magically wand and suspend “mark to market” valuations and hocus pocus the financial crisis is over.  All of those toxic assets and financial instruments on the books of the financial institutions at the center of this crisis would turn “valuable” again.  This is definitely too good to be true.

What are the auditors and financial analysts saying about the possible suspension of “mark to market” (hat tip to Calculated Risk)? 

“Suspending mark-to-market accounting, in essence, suspends reality.”
Beth Brooke, global vice chair at Ernst & Young LLP, WSJ, September 30, 2008

“Blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick.”
analyst Dane Mott, JPMorgan Chase & Co., Bloomberg

“Suspending the mark-to-market prices is the most irresponsible thing to do. Accounting does not make corporate earnings or balance sheets more volatile. Accounting just increases the transparency of volatility in earnings.”
Diane Garnick, Invesco Ltd., Bloomberg

These quotes are from people who rely on disclosure standards like “mark to market”.

It is shameful to try and scapegoat a disclosure standard such as “mark to market” for our financial crisis.  Financial institutions who invested heavily in subprime mortgages and mortgage backed securities failed to assess the risk involved with those assets.  They were blinded by greed.  Now, some institutions want to cover-up their failures with hocus pocus accounting.  They can’t handle the truth that “mark to market” is telling them – they are broke.

Why should this matter to us?  First, we as taxpayers are about to inherit these toxic assets and financial instruments with this $700 billion bailout.  Maybe, it doesn’t matter to Secretary Paulson (former CEO of Goldman Sachs) that we have an accurate and transparent valuation of these toxic assets and financial instruments.  Secondly, most of us are connected to the stocks of these financial institutions in some way either through direct stock ownership, mutual funds, pension funds, 401ks or customers.  We (including our agents at pension funds, mutual funds and 401K) must have clear and transparent disclosure of the toxic assets and financial instruments that these financial institutions own.  The suspension of “mark to market”, without a better alternative, will result in the same accounting shenanigans that brought us Enron, Global Crossing, WorldCom, Health South Corporation, Arthur Anderson, etc., etc.