The End of Mark-to-Market

Despite resistance by accounting firms, the SEC and FASB have issued a statement today easing restrictions on mark to market accounting.

Via the Washington Post:

“When an active market for a security does not exist, the use of management estimates that incorporate current market participant expectations of future cash flows, and include appropriate risk premiums, is acceptable.”

So what does this mean? Previously, a firm was forced to value an asset based on what that asset would currently sell for. This can create problems on a firm’s financial statements by making the firm appear more or less valuable than it really is.

The first situation is best illustrated by the example of Enron. Using mark to market accounting, Enron recognized revenues that would not actually be realized for several years, making the company’s assets appear much greater than they actually were. Warren Buffet referred to this kind of abuse of the mark to market concept as “mark to myth,” deliberately inflating the earnings of a company based on highly speculative future values of current assets.

The second situation is one currently being experienced by banks and other mortgage lenders throughout the United States: because no one is willing to buy mortgages and mortgage-backed securities, their values are basically zero, even if based on a loan that is in good shape and currently generating revenue. For example, if a family has a $300,000 loan for their home, both parents work and make their mortgage payments on time every month, the loan is still counted as worthless under mark to market even though the bank who issued the loan is earning interest income. This significantly reduces the net worth of the bank and has contributed to bank failures in the last few months.

The statement from the SEC and FASB above is meant to alleviate the second situation. It allows mortgage loans and mortgage-backed securities to be valued based on the income currently being generated, taking into account the time value of money. It helps keep banks from failing, and it doesn’t take $700 billion dollars to do it.

Update: Added relevant links and tags.

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