Understanding Mark-To-Market Accounting

While following the stock market gyrations of the past eighteen months, you undoubtedly have heard the term “mark-to-market accounting” and wondered what it means. The goal of this article is to provide a better understanding of what mark-to-market is and why it is playing an important role in the economic issues we are facing today.

The official definition of mark-to-market (also known as fair market value), from an accounting standpoint, is a standard of assigning a value of a financial instrument, based on the current fair market price. The use of mark-to-market accounting has been in practice in the U.S. since the early 1990’s, but the use of it has increased in the last ten years as investors have required more up-to-date information on a company’s assets.

Let’s consider an example of how the use of mark-to-market accounting played a role in the current economic situation. In 2007 the housing market started to look shaky. As cracks began to appear in the system, especially with default rates in subprime lenders, two hedge funds at Bear Stearns blew up and had to unload mortgage-backed securities at prices that were well below fair market value. When Bear Sterns was forced to lower the value of their mortgage securities, it caused a snowball effect and other financial institutions had to change the value of their assets to mirror the recently depressed prices.

In many ways, this would be like a situation where your neighbor had to quickly sell their house to settle a divorce. Due to the circumstances, the selling price of the house would be much lower than the going market price. In this example, let’s say that your neighbor’s house sells at 20 percent below market value. In the world of mark-to-market accounting, your house would then be valued at 20 percent less because your neighbor had to sell under stressful circumstances.

On April 2, 2008 the Financial Accounting Standards Board (FASB) decided to expand the number of securities that were exempt from mark-to-market accounting. Banks and financial institutions can now use other models to evaluate their assets when markets are distressed. The FASB was smart to put in rules that force the financial institutions using these models to properly disclose how they valued their securities.

We believe that the new rules give banks some leniency in interpreting the value of the securities they own, especially in times of market distress. However, we believe the new rules also limit the ability of banks to abuse the new rules by overestimating the price of their securities. It’s too early to say whether this new rule will be successful but we are encouraged by what we have seen so far.