4/8/2008: Sabaziotatos on Minyanville's discussion of mark-to-market accounting

In a recent blog entry on Minyanville, John Mauldin discusses mark-to-market accounting and the SEC's recent "Sample Letter Sent to Public Companies on MD&A Disclosure Regarding the Application of SFAS 157 (Fair Value Measurements)." John argues that the phrase "unless those prices are the result of a forced liquidation or distress sale" in the SEC letter constitutes a change in accounting rules:

"Thus it should not come as a surprise to you, gentle reader, that the rules have been changed in much the same way as in 1980."

That John has misinterpreted the SEC's letter is clear from the fact that the phrase John quotes from the letter is part of FASB 157, which reads:

"A fair value measurement assumes that the asset or liability is exchanged in an orderly transaction between market participants to sell the asset or transfer the liability at the measurement date. An orderly transaction is a transaction that assumes exposure to the market for a period prior to the measurement date to allow for marketing activities that are usual and customary for transactions involving such assets or liabilities; it is not a forced transaction (for example, a forced liquidation or distress sale)."

Thus, the phrase John quotes does not constitute any change in accounting rules, but is merely a part of FASB 157.

Be that as it may, John's misinterpretation of the phrase in the SEC's letter is beside the point. What is more interesting is the fact that John goes on to argue that the supposed "change in accounting rules" causes a lack of transparency:

"[The change of rules] clearly creates a lack of transparency. The whole reason to require banks to mark their assets to market price rather than mark to model was to provide shareholders and other lenders transparency as to the real capital assets of a bank or company."

In other words, John is arguing: Before the SEC's letter, mark-to-market accounting provided transparency; the SEC's letter, however, changed accounting rules so that transparency is now lacking.

In my opinion, what has created a lack of transparency is not the LACK of mark-to-market accounting, but mark-to-market accounting itself.

As Plantin, Sapra, and Shin in their paper "Marking-to-Market: Panacea or Pandora's Box?" write:

"A bad outcome for the asset [for example, an increase in the default rate for mortgages backing an RMBS] will depress fundamental values somewhat, but the more pernicious effect comes from the negative externalities generated by other firms selling. When others sell, observed transaction prices are depressed more than is justified by the fundamentals, and exerts a negative effect on all others, but especially on those who have chosen to hold on to the asset. Anticipating this negative outcome, a short-horizon firm will be tempted to preempt the fall in price by selling the asset itself. However, such preemptive action will merely serve to amplify the price fall. In this way, the mark-to-market regime generates endogenous volatility of prices that impede the resource allocation role of prices."

Finally, John argues that the supposed "change in accounting rules" can be a source of manipulation:

"[C]an a forced liquidation or distress sale be from a margin call? Obviously the answer is yes. But as Barry Ritholtz points out, this opens the door for some rather blatant potential manipulation. If a bank makes a margin call to hedge funds or their clients to make the last price of a similar derivative on their own books look like a forced liquidation, do they then get to not have to value the paper at its market price? Is this not an incentive to make margin calls? One price for my customers and a different one for the shareholders? If a hedge fund was forced to sell assets and then it found out that the investment bank is valuing them differently on its books than the price at which it was forced to sell, there will be some very upset managers and investors. Cue the lawyers."

All John has demonstrated here is the circular nature of mark-to-market accounting. As Professors Stella Fearnley and Shyam Sunder in their article "Pursuit of convergence is coming at too high a cost" write (admittedly with respect to bubble inflations, but just as validly of bubble deflations):

"The problem is that [fair value accounting] assumes markets have good information from inputs such as financial reports and credit ratings. But there is a circularity built in: if credit raters and investors get their information from accounting numbers, which are themselves based on prices inflated by a market bubble, the accounting numbers support the bubble. So instead of informing markets through prudent valuation and controlling management excess, "fair" values feed the prices back to the market."

In other words, given the circularity of mark-to-market accounting, it should not surprise John that a transaction by a bank in the market can influence the marking of an asset of the bank to market. How could things be any different? Mark-to-market accounting absolutely encourages market manipulation.