5/2/2008: Vinod Kothari on mark to market accounting

Excerpts from Sentimental Accounting: Is it time to question mark to market?
By Vinod Kothari


First, on the pro-cyclicality. A business cycle arises when there are forces that move the market further away from equilibrium, when the market is already away from equilibrium. There are short-term self-cancelling spikes in markets but the central tendency of all markets is convergence. When losses exacerbate losses, or gains propel gains, the result is a business cycle. In normal circumstances, the beauty of the marketplace is that people hold different, and mutually opposite views on a certain thing. That is why they trade, and do so happily. In the MTM scenario, since every player in the market is an MTM player, everyone has losses to report on the P&L the moment the market takes an adverse turn and there is a broad-based fall in prices of financial assets. Though the loss is still a notional loss, the equity gets eroded. Equity is the basic premise on which all leverage is built in the world of finance – be it hedge funds, or CDOs or the banks. A dollar of equity being eroded might mean anywhere between 10 to 25 dollar of reduction of asset-holding capacity of the MTM player. This would mean, if the player was fully leveraged, it would have to shed assets or curtail exposures several times the notional loss. In a scenario where the market is already bad, the leveraged reduction in asset-holding ability would mean there are lots of sellers as compared to buyers. Obvious enough, this pushes the market further lower. This would mean more MTM losses, and more erosion of equity… Very quickly, we have the downside of the business cycle.