5/1/2008: Henry Kaufman on mark to market accounting

Excerpts from On Money and Markets, McGraw Hill, 2000
By Henry Kaufman

That highly securitized markets are, on the whole, more volatile than less securitized markets has important implications. In volatile markets -- as in recent times, and surely during periods in the future -- liquidity may disappear suddenly, accurate pricing becomes exceptionally difficult to obtain, and marking to market may be practically impossible.

Why is this so? And what are the consequences? To begin with, the price of the last trade may be completely invalid in rapidly moving markets, particularly for illiquid securities and certainly for most options. Moreover, the price that a dealer is prepared to quote may be little more than an indication of what the security is worth, not the price at which the dealer is actually willing to trade. Another dealer may quote -- on the same “indications-only” basis -- a wildly different price. For the institution trying to mark the position to market, there is simply no reliable arbiter of “true” price.

More than that, the price quoted may be valid for trading only a very small amount, not the full amount that the investor has in his portfolio.

…

The consequences of not being able to mark to market accurately are often far from trivial. At best, dealers face embarrassment when clients call attention to inaccurate estimates of portfolio returns. At worst, they face the calamity of enormous losses and the impairment of capital. [pp. 56-7]

In years past, the procedure of reevaluating the net asset values of portfolios on a daily basis (to reflect changes in asset prices) was practiced mainly by securities firms. ... Banks and insurance companies did not mark to market, and their regulators did not want them to do so. They mainly held securities on their balance sheets at book values. They did not recognize interim (or unrealized) profits or losses. They tended to buy and hold. The great bulk of their assets was not securitized, and was not amenable to repricing in an active secondary market.

But in recent years ... changes in accounting guidelines and regulatory rules have encouraged an irreversible movement toward greater marking to market by traditional institutions. Securitization has undermined the key argument against marking to market -- namely, that valid prices cannot be determined -- while the passage of time has worn down both official and industry opposition to the practice.

Even so, it is important to recognize that marking to market is an imperfect process, especially under difficult market conditions. Generally speaking, [in times of rising asset prices?] it tends to overstate values and to offer investors a kind of false comfort. When market conditions deteriorate and liquidity seizes up, no one can really claim that the last quoted price in organized markets (such as the NYSE) or quoted by the dealers in the over-the-counter market is the real market value – at least not without taking into consideration the size of an intended trade, the credit quality of the issuer, the activity of other market participants, and related dimensions of the transaction. [pp. 316-7]