Friday, October 03, 2008

What is Mark-to-Market and Did It Cause A Panic?

Lately you've been hearing a lot about an esoteric accounting rule called "Mark-to-Market" (here in out referred to as M2M). Your eyes probably glaze over, but this accounting rule is partially to blame for the recent panic. Don't get me wrong, the underlying problems of this financial crisis are loans made to people who couldn't afford to pay them back (as well as credit agencies and appraisers), but the actual panic and seizure of the credit markets may be due more to M2M than anything.

What exactly is M2M? Its actually a reasonable method of valuing assets during normal times - it requires a company to value their assets at current prices on their books. Sounds reasonable. The problem is that it goes further than that, it has an effect on the capital structure of a company and recently has caused several companies to become insolvent......on paper.

Let me give you an example (I'm adopting this from Brian Wesbury):

You own a home worth $300,000 and you have a $250,000 loan in which you are making payments. Under Mark-to-Market rules if the value of that home drops to say $230,000 the bank will call you up and say "the value of your home has dropped, you need to pay us $20,000 (the difference between the loan value and home value) or we're going to kick you out". Needless to say most Americans would end up losing their homes and exacerbating the problem. Most Americans can't just come up with $20,000. Most Americans however can continue to make payments on that loan (about 95% are right now current). Yes, their is more risk and if liquidated right now a loss would occur - but you don't need to liquidate your home right now, you can wait years to do so and with a high probability the home will be worth more than the loan.

The M2M accounting rules work to require institutions to come up with money for no other reason than because a security is suddenly valued lower, sometimes for no good reason. A security that the institution may in fact hold until maturity and have a reasonable expectation of receiving most of the money back.

This insolvency test put Fannie and Freddie into government hands and each was given a line of credit of up to $100 billion.......of which they've used none of it - they both have positive cash flow. Of course, both entities were destined to fail, but that's another story.

I'm not making the arguement that we shouldn't use Mark-to-Market to help us understand liquidation values - but when its use causes a potential time bomb and leads to makes very little sense.

Most of the panic of these past few weeks has been caused by Mark-to-Market rules, the other to the Lehman failure (which may not have failed if these rules had been eased). The Lehman failure led to a money market fund "breaking the buck" which caused even more fear and panic and let to a complete seizing up of the credit markets.

Today's passage of the bailout bill and the SEC's easing of the mark-to-market rules will hopefully create an environment where we can work on the true underlying problems we face.

Scott Dauenhauer CFP, MSFP, AIF