Mark to Market... Mark to Model... Mark to Hope...
From
the International Association of Risk and Compliance Professionals
(IARCP)
What is
Mark to Market
Accounting (or Fair Value Accounting)
Mark-to-market (MTM) is the
valuation of assets at their current market
price.
Companies value assets that are
on their balance sheets according to the market price, or the latest
market indicators of the price that those
assets could be sold for immediately.
Mutual funds that
own stocks mark to market and report the value every day. Publicly
held firms mark to market each quarter.
Once upon a time all asset could have a mark to market value. In recent
years, we have derivatives or financial instruments for which book
valuation is simply impossible.
On the positive side
Mark-to-market
is the most honest and real way to price assets.
On the negative side
1. Today we can value according to the current market price, and use
it as a basis to make informed decisions. But
there is no guarantee that future transactions will realize similar
values.
2. If an asset is
trading in small quantities, marking to market is more meaningful. A
firm with a large position in that
asset can not really mark to market, as the more it sells, the more
the price declines.
3. If the markets are
not liquid, establishing a market price
is not easy.
4. The
market value is not always reflecting the
real value. In a market crisis panic
leads to very low prices.
5. The market
crisis of 2007 is caused by mark-to-market
accounting in an illiquid market.
Let's follow what has happened:
We have
declining housing prices...
... that
reduce the value NOT ONLY of
defaulting mortgages...
...
but ALL mortgages and all
mortgage-related securities...
... because
the market-bottom prices become the new standard
for the valuation of all similar securities held by all firms under
mark-to-market.
Foreclosures depress housing
prices...
...
capital values decline...
...
banks try to maintain the
capital required by regulation and fail...
...
balance sheets under
mark-to-market start to show insolvency...
...
banks begin
fire sales of assets to
raise capital to meet regulatory
requirements...
...
credit rating agencies see the
problem banks face and downgrade them...
...
which makes borrowing to meet
capital requirements more difficult....
...
and it can lead to a
downward death spiral for financial
institutions.
"During the 1980s, our underlying economic problems were far more
serious than the economic problems we're facing this time around.
The country's 10 largest banks were loaded up with Third World debt
that was valued in the markets at cents on the dollar.
If we had marked those loans to market prices,
virtually every one of them would have been insolvent."
William Isaac, former chairman of
the FDIC, in The Wall Street Journal
What is
Mark to Model
Accounting
Mark-to-market is the valuation
of assets at their current market price.
Mark-to-model is the valuation of assets
based on guesswork, assumptions and financial models.
Mutual funds mark
to market every day, and they have no difficulties doing that as
they hold liquid assets. But for those who hold illiquid assets or
assets for which there is no market, like mortgage-backed securities
and venture capital investments, marking to market is impossible.
The only practical valuation
technique for firms that have complex financial instruments in their
portfolio is marking to model.
Example: A firm acquires 1,000 shares
at a price of USD 100 per share. Some months later these shares are
trading at USD 60. If the firm marks to market, it must report a
loss to shareholders. If the firm marks to model, continues to value
the shares at USD 100. Only if it sells the shares will the firm
report a loss.
On the positive side
Not all securities are liquid as
shares for which anyone can look up the price at any given moment.
Mark to model accounting gives us the opportunity to value assets.
On the negative side
1. The assumptions and the use
of models that do not work can lead to mark-to-imagination or
mark-to-hope.
2.
Models break down dramatically
during abnormal times.
FASB Statement No. 157 - Fair Value
Measurements
According to the Statement No 157, fair value is a
market-based measurement, not an
entity-specific measurement. Therefore, a fair value
measurement should be determined based on the assumptions that
market participants would use in pricing the asset or liability.
As a basis for
considering market participant assumptions in fair value
measurements, this Statement establishes a fair value hierarchy that
distinguishes between
(1) market
participant assumptions developed based on market data obtained from
sources independent of the reporting entity (observable inputs) and
(2) the reporting
entity’s own assumptions about market participant assumptions
developed based on the best information available in the
circumstances (unobservable inputs).
The notion of
unobservable inputs is intended to
allow for situations in which there is little,
if any, market activity for the asset or liability at the
measurement date.
In those
situations, the reporting entity need not undertake all possible
efforts to obtain information about market participant assumptions.
However, the
reporting entity must not ignore information about market
participant assumptions that is reasonably available without undue
cost and effort.
This Statement clarifies that market
participant assumptions include assumptions about risk, for
example, the risk inherent in a particular valuation technique used
to measure fair value (such as a pricing model) and/or the risk
inherent in the inputs to the valuation technique.
A fair value
measurement should include an adjustment for risk if market
participants would include one in pricing the related asset or
liability, even if the adjustment is difficult to determine.
Therefore, a
measurement (for example, a mark-to-model
measurement) that does not
include an adjustment for risk would not
represent a fair value measurement if market participants would
include one in pricing the related asset or liability.
This Statement clarifies that market participant assumptions also
include assumptions about the effect of a restriction on the sale or
use of an asset.
A fair value
measurement for a restricted asset should consider the effect of the
restriction if market participants would consider the effect of the
restriction in pricing the asset.
From the Case against Fair Value Accounting
By A. Rashad Abdel-khalik, University of Illinois
Reporting Failure as a Success and Success
as a Failure
This concern
relates to the valuation of financial liabilities, whether
standalone instruments or derivatives.
To highlight this
particular drawback, I will focus on fixed-income instruments.
Valuing such instruments at their fair values and taking the
resulting changes to the income statement give rise to this
phenomenon of reporting failure as success, and vice versa, as
elaborated below.
In general, the value of fixed-income financial instrument moves
opposite of the movement of changes in market rates of interest
(cost of capital).
As cost of capital
increases, investors demand higher return than the fixed-income
rate paid by the instrument. Consequently, the market (fair) value
of the instrument decreases, and vice versa.
Under FV accounting,
the borrowers who issue fixed-income instruments will recognize
gains equal to the decline in the market value of their debt that
arises from an increase in interest rates and will recognize
losses as the market value of their debt increases with the
decline in the market interest rates.
In an economic
sense, the fair value of debt is the real obligation conditional
on
(a) liquidating the position, and
(b) market stability.
Even when the
market rate of interest is stationary and there is an active
market, an unfortunate outcome of FV accounting is that the same
outcome noted above would be obtained as the borrower’s
creditworthiness changes.
This is precisely
where FV accounting leads to nonsensical and perverse results.
With a decline in
credit worthiness, borrowers become more risky as their risk of
default increases. To compensate for the increased risk, capital
market participants will demand higher risk premium and the market
value of debt declines.
Conversely, when
creditworthiness improves and the borrowers have superior credit
risk, the required rate of return on their debt declines because
the superior credit rating means that market participants will
require a lower risk premium than is being charged.
The increase in the
value of debt is a loss to the borrower and, under FV accounting;
such loss would be recognized in the income statement.
The two above-noted scenarios create a dilemma of different
dimensions.
On the one hand, both scenarios have the same outcome in that
lower market values result in the debtors’ recognition of gains,
while higher market values of debt results in the debtors’
recognition of losses.
On the other hand, the two scenarios signal different information:
in the first scenario, holding gain or loss arises from external
forces, while in the second scenario, holding gain or loss
emanates from internal forces.
The distinction
between internal and external forces is quite relevant to anyone
interested in the financial well being of the reporting firm.
The suggested high
degree of relevance of these scenarios arises from the fact that
the ―internal forces are pertinent to the evaluation of management
performance and success.
The perverse nature of
the outcome of this accounting process is that the debtors
recognize gains when they become more risky (failure is reported
as success), and recognize losses when they become less risky
(success is reported as failure).
To be sure, I am
not the first one to address this dilemma; in fact the minutes of
the FASB’s meetings show a discussion of this problem at different
times.
Expressing the
prevailing thought around the FASB, though not speaking for this
standard setting organization, Crooch and Upton (2001) have in
fact addressed this problem and offered examples by comparing
changes in creditworthiness of two hypothetical companies.
However, to this day,
I am unable to understand or be convinced of the proposition that
FV accounting in this situation (i.e., reporting gains for posing
greater credit risk and reporting losses for posing lower credit
risk) enhances transparency or information relevance.
To the contrary, I
believe it takes away from relevance and transparency and it could
be misleading to the average investor who relies on accounting
numbers as reported to measure firm performance.
The other side, of
course, is that every debt is owned by someone else outside the
debtor’s entity. As an asset for creditors, the market value of
investment in fixed-income securities will generate gains and
losses opposite that of the debtors’ position.
That is, the creditor
will recognize losses with a decline in the creditworthiness of
the issuer (debtor), and will recognize gains with the increase in
the creditworthiness of the issuer. In the absence of evidence on
impairment of the value of the asset, the holding gains or losses
are conditional expectations, just the same as they are for the
debtors.
Therefore,
the creditor’s recognition of these holding
gains or losses would also be misleading to average investor,
especially since these changes are not indicators of managerial
performance or action.
This is critical because no information is
provided on the degree and extent (or likelihood) of realizing the
holding gains and losses that are being recognized. As in the case
of the debtors’ reporting, creditors’ reporting of unrealized
capital gains and losses would be aggregated with realized
earnings and, once again, relevance and transparency are brought
into question.
Whether it is the case of debtors or
creditors, the increase in market interest rate has the same
outcome as the downgrading of the debtors’ creditworthiness
(increasing the debtors’ risk) and vice versa. Two concerns with
this outcome:
(1) External users
of financial statements have no way of disentangling the
information to identify the source of the gain and to be able to
differentiate between the external and internal sources of the
reported gains—i.e., whether it is increased market interest rate
vs. increased credit risk of the issuer.
(2) A more
disturbing feature of the above analysis is that it is not really
as a hypothetical situation as the illustration above implies.
Indeed, Katz (2008) reports that the 25 firms of the S & P 500
that have ―the biggest amounts of liability measured at fair
value, widening credit spread—an indication of a lack of
creditworthiness—spawned first quarter earnings gains ranging from
$11 million to $3.5 billion
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