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Accounting Rule: Mark to Market, Mark to Reality, or Mark to Fantasy

By: Richard Feldman

By: Richard Feldman, CFP®, MBA, AIF®

I have never heard people discuss accountants as much as I have over the last eighteen months of the economic downturn. It became even more acute on April 2nd when the Financial Accounting Standards Board agreed to alter an accounting rule, FAS 157, which is known as Mark to Market. This rule, depending on who you talk to, either brings clarity to bank balance sheets or has been one of the key destroyers of economic capital in the most recent recession.

Fair Value Accounting

Fair value accounting refers to the accounting standard of assigning a value to a position held in a financial instrument based on the current fair market price for the instrument or similar instruments. Fair value accounting has been a part of US Generally Accepted Accounting Principles (GAAP) since the early 1990s. The use of fair value measurements has increased steadily over the past decade, primarily in response to investor demand for relevant and timely financial statements that will aid in making better informed decisions. [1]

Former FDIC chairman William Isaac has placed much of the blame for the subprime mortgage crisis on the Securities and Exchange Commission and fair value accounting, especially the requirements for banks to mark-to-market their assets, particularly mortgage-backed securities.

Vicious Cycle

The accounting rules require companies to adjust the value of the marketable securities, such as mortgage-backed securities (MBS) to their market value. The intent of the rule is to help determine a price of a security at a moment in time rather than the historical cost of that security.

FAS 157 defines “Fair Value” as: “The price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.” FAS 157 took effect with fiscal years that began after November 15th, 2007.

The problem arose when the market for mortgage backed securities became distressed and very few securities traded on a daily basis. The volume of commercial mortgage backed securities issued from July through September of 2008 was zero in relation to the $60 Billion issued in the same period of 2007. Since the market for mortgage backed securities has become distressed, it is difficult to sell many MBS at anything other than distressed prices. This has caused financial institutions to use prices of distressed asset sales to value the securities on their books which may be lower than the discounted cash flow analysis of the pool of securities.

Since a lot of these securities were purchased using leverage/margin, the resulting write down of the mortgage securities owned caused margin calls to be made by lenders to financial institutions. This may have also caused banks to reduce the value of their regulatory capital which in turn caused them to raise more capital by selling securities into a distressed market. This caused further write downs.

FASB Eases Fair-Value Rules

Changes to fair value or mark-to-market accounting allow companies to use significant judgment in gauging prices of some investments on their books, including mortgage backed securities. Banks would be allowed to use internal models instead of market prices based on cash flow of securities in markets that have become distressed. FASB staff said banks should only disregard transactions that are not orderly including situations in which the seller is near bankruptcy or needed to sell the asset to comply with regulatory requirements.

Robert Willens, a former managing director at Lehman Brothers Holdings Inc. who runs his own tax and accounting advisory firm, estimates that the change in rules by the FASB could boost bank industry earnings by 20%.

Richard Dietrich, who is an accounting professor at Ohio State University, gave an example of Citigroup entirely reversing reported losses of $1.6 billion on so called Alt-A mortgages that were reported in their 2008 annual report.


Mark-to-market has as many proponents as detractors and there seems to be no wiggle room for either side. The believers in mark-to-market feel that it provides clarity and reality to bank balance sheets whereas the detractors feel that you are forcing banks to write down positions to fire sale prices that will not be sold or realized for several years creating a vicious cycle that has allowed short sellers to profit greatly and cause bank runs.

It will be interesting how the auditors of these large institutions interpret the new rules. There was a feeling that auditors who were trying to protect themselves from liability forced banks to use quoted security prices on similar securities to price their assets. Often times these quoted prices were on distressed asset sales by firms who had received a margin call or who needed to sell a position to increase regulatory capital so they would not be deemed insolvent. Accountants, particularly auditors, tend to be very conservative in opinions regarding financial statements so it will be interesting to see how the banks’ cash flow analysis on a lot of these asset values plays out.

[1] Wikipedia, Mark to Market Accounting, 04/12/2009