3/31/2008: Nouriel Roubini on mark-to-market accounting

Excerpts from Ten Fundamental Issues in Reforming Financial Regulation and Supervision in a World of Financial Innovation and Globalization
By Nouriel Roubini

Seventh, there are fundamental accounting issues on how to value securities, especially in periods of market volatility and illiquidity when the fundamental long term value of the asset differs from its market price. The current “fair value” approach to valuation stresses the use of mark-to-market valuation where, as much as possible, market prices should be used to value assets, whether they are illiquid or not.

There are two possible situations where mark-to-market accounting may distort valuations: first, when there are bubbles and market values may be above fundamental values; second, when bubbles burst and, because of market illiquidity, asset prices are potentially below fundamental values. The latter case has become a concern in the latest episode of market turmoil as mark-to-market accounting may force excessive writedowns and margin calls that may lead to further fire sales of illiquid assets; these, in turn, could cause a cascading fall in asset prices well below their long term fundamental value. However, mark-to-market accounting may also create serious distortions during bubbles when its use may lead to excessive leverage as high valuation allow[s] investors to borrow more and leverage more and feed even further the asset bubble. In either case, mark-to-market accounting leads to pro-cyclical capital bank capital requirement given the way that the Basel II capital accord is designed.

The shortcomings of mark-to-market valuation are known but the main issue is whether one can find an alternative that is not subject to gaming by financial institutions. Some have suggested the use of historical cost to value assets (where assets are booked at the price at which they were bought); others have proposed the use of a discounted cash flow (DCF) model where long run fundamentals – cash flows – would have a greater role. However, historical cost does not seem to be an appropriate way to value assets. The use of a DCF model may seem more appealing but it is not without flaws either. How to properly estimate future cash flows? Which discount rate to apply to such cash flows? How to avoid a situation where those using this model to value asset[s] subjectively game the model to achieve the valuations that they want as the value of the asset in a DCF model strongly depend on assumptions about future cash flows and the appropriate discount factor? Possibly mark-to-market may be a better approach when securities are held in a trading portfolio while DCF may be a more appropriate approach when such securities a[re] held as a long term investment, i.e. until maturity. But the risk of a DCF approach is that different firms will value very differently identical assets and that firms will use any approach different from mark-to-market to manipulate their financial results.

The other difficult problem that one has to consider is that any suspension of mark-to-market accounting in periods of volatility would reduce – rather than enhance – investors’ confidence in financial institutions. Part of the recent turmoil and increase in risk aversion can be seen as an investors’ backlash against an opaque and nontransparent financial system where investors cannot properly know what is the size of the losses experienced by financial institutions and who is holding the toxic waste. Mark-to-market accounting at least imposes some discipline and transparency; moving away from it may further reduce the confidence of investors as it would lead to even less transparency.

Some suggest that the problem is not mark-to-market accounting but the pro-cyclical capital requirements of Basel II; that is correct. But even without such pro-cyclical distortions there is a risk that financial institutions – not just banks - would retrench leverage and credit too much and too fast during periods of turmoil when they become more risk averse. Thus, the issue remains open of whether there are forms of regulatory forbearance - that are not destructive of confidence - that can be used in periods of turmoil in order to avoid a cascading and destructive fall in asset prices. But certainly solutions should be symmetric, i.e applied both during periods of rising asset prices and bubbles (when market prices are above fundamentals) and when such bubbles go bust (and asset prices may fall below fundamentals). But so far there is no clear and sensible alternative to mark-to-market accounting.