Investments, tenth edition

  Mark-to-Market Accounting: Cure or Disease? 

 As banks and other institutions holding mortgage-backed 

securities revalued their portfolios throughout 2008, their 

net worth fell along with the value of those securities. 

The losses on these securities were painful enough, but 

their knock-on effects only increased the banks’ woes. For 

example, banks are required to maintain adequate levels 

of capital relative to assets. If capital reserves decline, a 

bank may be forced to shrink until its remaining capital is 

once again adequate compared to its asset base. But such 

shrinkage may require the bank to cut back on its lending, 

which restricts its customers’ access to credit. It may also 

require asset sales, and if many banks attempt to shrink 

their portfolios at once, waves of forced sales may put fur-

ther pressure on prices, resulting in additional write-downs 

and reductions to capital in a self-feeding cycle. Critics of 

mark-to-market accounting therefore contend that it exac-

erbated the problems of an already reeling economy. 

 Advocates, however, argue that the critics confuse the 

message with the messenger. Mark-to-market accounting 

makes transparent losses that have already been incurred, 

but it does not cause those losses. Critics retort that when 

markets are faltering, market prices may be unreliable. If 

trading activity has largely broken down, and assets can 

be sold only at fire-sale prices, then those prices may no 

longer be indicative of fundamental value. Markets can-

not be efficient if they are not even functioning. In the 

turmoil surrounding the defaulted mortgages weighing 

down bank portfolios, one of the early proposals of then–

Treasury secretary Henry Paulson was for the government 

to buy bad assets at “hold to maturity” prices based on 

estimates of intrinsic value in a normally functioning mar-

ket. In that spirit, FASB approved new guidelines in 2009 

allowing valuation based on an estimate of the price that 

would prevail in an orderly market rather than the one 

that could be received in a forced liquidation. 

 Waiving write-down requirements may best be viewed 

as thinly veiled regulatory forbearance. Regulators know 

that losses have been incurred and that capital has been 

impaired. But by allowing firms to carry assets on their 

books at model rather than market prices, the unpleas-

ant implications of that fact for capital adequacy may be 

politely ignored for a time. Even so, if the goal is to avoid 

forced sales in a distressed market, transparency may nev-

ertheless be the best policy. Better to acknowledge losses 

and explicitly modify capital regulations to help institu-

tions recover their footing in a difficult economy than to 

deal with losses by ignoring them. After all, why bother 

preparing financial statements if they are allowed to 

obscure the true condition of the firm? 

 Before abandoning fair value accounting, it would be 

prudent to consider the alternative. Traditional historic-

cost accounting, which would allow firms to carry assets 

on the books at their original purchase price, has even less 

to recommend it. It would leave investors without an accu-

rate sense of the condition of shaky institutions, and by the 

same token lessen the pressure on those firms to get their 

houses in order. Dealing with losses must surely require 

acknowledging them.  

 WORDS FROM THE STREET 

 Critics of fair value accounting argue that it relies too heavily on estimates. Such esti-

mates potentially introduce considerable noise in firms’ accounts and can induce great 

profit volatility as fluctuations in asset valuations are recognized. Even worse, subjective 

valuations may offer management a tempting tool to manipulate earnings or the appar-

ent financial condition of the firm at opportune times. As just one example, Bergstresser, 

Desai, and Rauh  

6

   find that firms make more aggressive assumptions about returns on 

defined benefit pension plans (which lowers the computed present value of pension obliga-

tions) during periods in which executives are actively exercising their stock options.

  

 A contentious debate over the application of fair value accounting to troubled financial 

institutions erupted in 2008 when even values of financial securities such as subprime 

mortgage pools and derivative contracts backed by these pools came into question as trad-

ing in these instruments dried up. Without well-functioning markets, estimating (much 

less observing) market values was, at best, a precarious exercise. In 2012, for example, 

employees at Credit Suisse were convicted of intentionally overstating the value of thinly 

traded mortgage bonds during the financial crisis to improve the apparent profitability of 

their trading activities. 

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Final PDF to printer

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P A R T   V

 Security 

Analysis

 Many observers feel that mark-to-market accounting exacerbated the financial melt-

down by forcing banks to excessively write down asset values; others feel that a failure to 

mark would have been tantamount to willfully ignoring reality and abdicating the respon-

sibility to redress problems at nearly or already insolvent banks. The nearby box discusses 

the debate.