Category Archives: Mark to market

Two Nobel laureates have entered into the valuation debate and are calling upon financial institutions to provide a more accurate portrait of their illiquid assets to investors. Robert Merton first commented on the issue in a column for the Financial Times on Aug. 18 in which he said banks that opposed mark to market accounting were simply looking to conceal depressed prices.

Myron Scholes echoed those comments in an Aug. 19 interview with Bloomberg, with both men urging banks to mark more securities to market and put any hard-to-value securities on public exchanges wherever possible.

According to Scholes and Merton, such a move would give investors better data on prices to more accurately reflect the value of an institution’s debt and equity securities.

Scholes and Merton shared the Nobel Prize for economics in 1997 for helping invent a model for pricing options. They also learned about the danger of leverage firsthand. Merton and Scholes were the creators of Long-Term Capital Management, whose collapse in 1998 was the largest-ever hedge fund failure at the time.

At one point, Long-Term Capital Management held more than $100 billion in assets. However, the firm was highly leveraged, borrowing billions to make big bets on esoteric securities. When the markets took a turn for the worse in 1998, the bets backfired and Long-Term Capital Management lost most its money. Fearing that its collapse could set off a full-scale market meltdown, the U.S. Federal Reserve stepped in to orchestrate a bailout by 14 lenders.

Ironically, there was only one naysayer among the 14 banks that agreed to the rescue: Bear Stearns.

It’s official. The Financial Accounting Standards Board (FASB) has approved relaxing fair value, or mark to market, accounting rules, a move that gives banks leeway to assign a value to investments based on their own internal model of what the assets might sell for in the future rather than in current market conditions.

Revising the accounting standard will be a boost to banks, which stand to see a 20% or more gain in their quarterly operating profits. 

The FASB voted on easing the mark to market rule on April 2. 

Critics of the rule change say it will lessen the transparency of a company’s fiscal health and may encourage some institutions to inappropriately raise the value of certain assets to give the appearance of rosier balance sheets.

As for investors, without the early warning signs created by mark to market accounting, they could very well find themselves left in the dark when it comes to detecting potential problems of a particular financial market. If problems do arise, it may be too late for them to do anything about it. 

Proposed revisions to the fair value accounting standard known as FAS 157 have garnered harsh criticism from those who say the changes are ambiguous and undefined, lack substance and will create further inconsistencies as banks assign value to some assets. 

Under current FAS 157 rules, three different valuation levels exist for banks to price their mark-to-market holdings. Level 1 assets have readily observable prices and trade in active markets. Level 2 assets do not trade actively nor do they have easily obtainable prices. Level 3 assets include the most problematic holdings, such as collateralized debt obligations (CDOs), collateralized mortgage obligations (CMOs) and other exotic derivatives created by prime and subprime mortgages.  

Level 3 holdings are considered illiquid, with market prices so scarce that companies use internal models to gauge their value. In other words, placing a value on these assets is subjective and largely depends on assumptions or opinions. For this reason, Level 3 valuation is often referred to as “mark-to-myth” or “mark-to-imagination.” 

The new proposals for FAS 157 assume that “inactive” markets are the same as “distressed” markets. Moreover, the revisions essentially would allow banks to move more hard-to-value assets into Level 3. This means a company will be able to “handpick” the most appealing value for its assets, while casting aside any that might cause them financial turmoil. 

The bottom line: The proposed amendments to FAS 157 appear to squash the intended purpose of fair value accounting altogether. 

The Financial Accounting Standards Board plans to vote on the revisions to FAS 157 on April 2.