Mark-to-Market Accounting

I was reading a list of 10 unresolved economic issues by David Merkel and #4 caught my eye (if anyone has anything to add on the other issues, please do so):"On a mark-to-market basis, market values for commercial real estate have fallen dramatically. Neither RIT stocks nor carrying values for loans on the books of banks reflect this yet. Many banks are insolvent at market-clearing prices for commercial real estate."

I've read a little bit about mark-to-market accounting and it seems an interesting topic. Wikipedia defines mark-to-market, or fair value, accounting as "the accounting standards 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." Since the early 1990's, this has been considered a standard accounting practice by GAAP. Interestingly, there are some who use this standard as a scapegoat for the real estate housing crisis, and they make a fair point: it is one thing to value actively traded securities at market value, but a loan made for a house may see its current value swing in the short-term though the long-term value may eventually justify the loan. Is it fair to allow short-term swings in the value of a simple loan to significantly affect the books of a bank?

As of July, accounting rules were a mess, according to The Economist: "The existing standards are a shambles, a patchwork of inherited rules riddled with escape clauses. They mix mark-to-market values with the more traditional practice of carrying assets at their cost and impairing them only when managers and auditors think fit. There are also several different ways of recognising losses. The result is that the balance-sheets of different banks are not always directly comparable." The article goes on to discuss am IASB-proposed change to the standards that makes a lot of sense to me, namely that simple loans be written at cost while more complicated securities that are actively traded, such as derivatives and other mortgage-backed securities, be marked at market value.

Now, FASB is thinking about tightening the standards. I disagree with this idea, and much prefer the July IASB proposal referenced in The Economist article linked above: "Loans and securities which share the characteristics of loans—in other words, assets that derive their value only from interest and repayment of principal—will be held at cost, provided banks can show they will hold them for the long term. Everything else, including equities, derivatives and more complicated securities, will be held at fair value." (emphasis mine)

I think that some of these banks are only insolvent *at this time* due to the pricing bust in real estate; if the economy turns around as we all hope, these assets may increase in value to the point where the loan originator is no longer under water. It is more than fair that banks be required to price some of the complicated instruments they developed at market value, as they are actively traded. However, to be forced to price loans that derive value from repayment of original principal and interest at current market value is unfair. In my mind, tightening these standards would unnecessarily exacerbate an already miserable situation. Note that it is imperative that banks, or some agency, attempt to report what all assets might currently fetch in the market. Also note that I do not have a strong opinion on whether mark-to-market accounting did indeed force the current crisis. I am only focused on how I believe the rules should be written. By following the IASB proposal, Merkel's point #4 may not be a huge problem.

One thing that is clear, however, is the need for accounting standards to be set independent of political pressure, which too often is a short-term response to whatever the current crisis may be. The Economist writes about this quite well: "standards-setters must rebuild their independence after the political assault they have faced in both America and Europe. The best way to do this is to continue to merge their standards, including those for financial firms, into one global rulebook. That should help restore confidence by preventing regulatory arbitrage between jurisdictions and diluting the voices of powerful national lobbies. Investors need not trust in God, but they must be able to trust accounts."