Jeffry L. Davis Since joining Economists Incorporated, Jeffry L. Davis has worked on numerous matters involving insider trading, securities fraud, damages, and antitrust issues. Previously he was Director, Economic and Policy Research at the Securities and Exchange Commission.

The Role of Mark-to-Market Accounting in the Current Financial Crisis

In recent months a fairly obscure accounting policy, usually referred to as mark-to-market accounting or fair value accounting, has been tarred by a number of prominent parties as a significant contributor, if not a major cause, of the unfolding financial crisis in this country. William Isaac, former Chairman of the FDIC, for example, has charged that the mark-to-market rule forces firms to value their assets at “unrealistic, fire-sale prices.” In fact, he claims that this rule is the primary cause of the crisis. The Emergency Economic Stabilization Act of 2008 clarified the Securities and Exchange Commission’s (SEC’s) authority to suspend mark-to-market accounting and ordered it to study the issue.

In brief, the mark-to-market accounting rule requires public companies, including banks, to value certain assets (such as mortgage-backed securities) at their current market values, that is, at values that could be realized by selling the assets on the valuation dates. On its face, such a rule does not sound controversial. After all, what better value exists than a current market value? Mr. Isaac and others, however, argue that current market values in a financial crisis are not good measures of the economic value of the assets because the market values are unrealistically depressed due to “temporary impairment.”

It is beyond the scope of this brief article to draw any conclusions about the role of the mark-to-market rule in precipitating or contributing to the current financial crisis. Instead it will identify the key issues concerning this rule and explore briefly how they might be resolved. A good starting point is to consider the purpose of accounting, which is to provide the necessary information to business owners, investors, and lenders to permit them to make sound economic decisions. To accomplish this purpose, accounting must accurately portray the economic value of the assets held by a company.

The mark-to-market rule was intended to serve this purpose; whether it in fact does so is at issue. The critics of the rule argue that in a crisis the rule fails to serve this purpose because current market values are distorted. The distortion arises because liquidity has dried up so much that there are few sales and the sales that do occur are made at distressed prices by companies that must sell. Other companies that hold the same or similar assets must then value those assets based on the distressed sale prices, even though they may have no intention of selling the assets in the near future. Under this scenario, it is argued, current market values do not reflect true economic values.

This argument, if true, does not explain why liquidity would dry up in the first place, but it may explain why the mark-to-market rule may exacerbate a liquidity crisis once begun. It suggests, therefore, that easing of the rule in a crisis might help prevent the crisis from worsening. Of course, if the rule is to be suspended in a crisis, what rule should take its place? How should firms value their assets in a financial crisis to better reflect true economic values?

Mr. Isaac and others have suggested allowing firms to use discounted cash flow analysis to value assets in a financial crisis. Discounted cash flow analysis is a cornerstone of modern finance and none can deny that, properly done, a discounted cash flow analysis would produce a good estimate of the economic value of an asset. Unfortunately, it could be difficult to reach a consensus on the proper way to do a discounted cash flow analysis in a financial crisis. The sticking point would be agreeing on the proper discount rate to use in conducting the analysis.

To conduct a discounted cash flow analysis, the projected cash flows over the life (or holding) of the asset must be discounted at an interest rate that accurately reflects the riskiness of those cash flows. The less certain it is that the projected cash flows will be realized, the greater the discount rate must be.

Choosing the appropriate discount rate is not always easy even in so-called normal times. The challenge is much greater in a financial crisis. If firms are allowed to use their discretion in choosing a discount rate, this may bring into question the reliability and comparability of the accounting results reported by public companies. And, if this results in undermining public confidence in the reported accounting results, the proposed cure may further contribute to the crisis.

On September 30, 2008, the SEC and the Financial Accounting Standards Board responded to the criticisms of the rule by issuing new guidance on mark-to-market accounting. In issuing its new guidance, the SEC recognized the problems posed by disorderly and inactive markets and made it clear that companies may use “internal assumptions,” but it was careful to insist on “clear and transparent disclosure” of those judgments. In short, the SEC action offers clarification to firms on the use of their discretion to avoid abuse by requiring disclosure of the exercise of that discretion.

Additional Articles in Special Issue of Economists Ink November 2008

Financial Crisis: What Went Wrong?

Twin Crises: In Public Confidence and in the Housing Market

Auctions for Mortgage-Backed Securities