On Mark-to-Market and Its Supposed Suspension

One of the most misunderstood episodes of the financial crisis concerned the events surrounding fair value accounting, specifically in reference to what securities should be marked to market.  Most recently, Steve Forbes criticized the re-imposition of any such rule on banks:

An economic version of the bubonic plague is ready to reemerge: mark-to-market accounting. This rule was the principal reason that the financial disaster of 2007–09 threatened to destroy our financial system. The system could have survived the losses from subprime mortgages and other unsound exotic transactions–though there would have been substantial casualties among players–just as we survived the raft of bad Latin American and commercial real estate loans in the 1980s and early 1990s.

In effect, mark-to-market accounting rules forced financial institutions to value securities for capital purposes as though they were day-trading accounts. Traditionally, an asset was held at book value for regulatory capital purposes unless it was disposed of or became impaired. In 2007 that standard was overturned by the Financial Accounting Standards Board (FASB). When panic set in regulators and auditors forced banks and insurers to write down the values of assets to absurdly low levels that weren’t even remotely justified by their cash flows. Forbes columnist and noted economist Brian Wesbury explained in his book It’s Not as Bad as You Think: Why Capitalism Trumps Fear and the Economy Will Thrive (John Wiley & Sons) that if mark-to-market had been in effect during our last big banking crisis some two decades ago the largest commercial banks in the country would have been destroyed. Those institutions had Latin American loans equivalent to 260% of their capital. On a mark-to-market basis those loans would have fetched barely ten cents on the dollar.

Mark-to-market is like being told to mark down the value of your house to a price that it will fetch within the next 24 hours. An absurdly destructive concept. But it explains why the massive losses financial institutions took were mostly book losses and not actual cash losses on bad paper.

Mark-to-market accounting was banned in 1938 because it was contributing to financial distress during the Great Depression. In March 2009 Congress forced a change: The FASB would allow cash flow accounting to be used when markets were illiquid. Overnight the terrible bear market ended, and the credit system came back to life.

But did Congress actually force a change, or just imply that they may take some action?  The language in many articles discussing the events during that tumultuous period is vague, whether deliberately or not.  Earlier this spring, another author was characteristically as blunt about the supposed suspension of the rules, although his conclusion was different—intriguing because he also harked back to the Latin American debt crisis:

Between September, 2008, and March 2009, the Fed backstopped the entire US banking system—but it still wasn’t enough. The losses were too great, the holes in the balance sheets too big.
So on April 2, 2009, a key FASB rule was suspended: Specifically, rule 157 was suspended, related to the marking of assets to market value—the so-called “mark to market” rule.
Essentially, the mark-to-market rule means marking an asset to the value it can fetch in the open market at the date of the accounting period. If I own a share of XYZ stock which I purchased at $100, but today it’s quoted at $60, I mark it on my books at today’s market price—$60—not at the purchase price—$100. The reason is obvious: By marking the asset to market value, I’m giving a realistic picture of the financial shape of my company or bank.
However, ever since April 2, 2009, when the FASB rules were suspended, the American banking system has been floating on nothing by air. By suspending rule 157, none of the banks have had to admit that they’re insolvent. With the suspension of mark-to-market, accounting rules are now basically mark-to-make-believe.
Why was FASB rule 157 suspended?
Geitner, Bernanke and Summers seem to have been trying to duplicate what Volcker did so successfully in 1982. This period since March 15, 2009, when the suspension of the rule went into effect, has been called “extend and pretend”.
Has it worked?
Prima facie, it would seem so. The banks seem to be stable, and have been raking in the big bucks ever since the rule was suspended. The markets—from their March ’09 lows—have rocketed onward and upward. In fact, Citigroup stock has quadrupled, Goldman Sachs has doubled—everything is wonderful! Nothing hurts!
However, the basic problems in the banking system remain: The banks are still broke, because of the same reason—the toxic assets on their books.

And referring back to the Latin American crisis:

In 1982, many of the banks hit by the Latin American debt crisis were effectively insolvent. Paul Volcker, as the then-Chairman of the Federal Reserve—charged with overseeing the banking system—effectively cast a blind eye on this banking insolvency.
Volcker’s reasoning seems to have been that the US banks were not broke—they were just getting temporarily squeezed. Volcker seems to have concluded that time would heal the balance sheet wounds caused by the Latin American defaults. Therefore, to hold the banks to the letter of the accounting rules would likely drive one or more of them broke, to no useful purpose—and it could potentially cause a bank panic and general financial crisis. But to pretend (for a while) that all was right with the US banks would avoid a potential panic—so long as the crisis sorted itself out and the banks repaired themselves by writing off and renegotiating their toxic Latin American debt.
Volcker gambled, and won: The US banks indeed took the Latin American debt hit, but grew their way out of their hole.

Regardless of the conclusions, both articles make the same claim: fair-value accounting was either suspended or forced out of existence, by either Congress or FASB or both.  The specifics on the mechanics of what actually occurred remain cloudy, however.  For instance, were the banks able to value anything based on cash flow models rather than market prices, or merely just certain loans, as the Forbes article suggests?  Was the problem really loans to small businesses or complex derivatives or securitized loans which did trade, but whose markets suddenly dried up—a question the Forbes article assiduously avoids, seemingly claiming that banks were forced to value their entire loan portfolio in some market, a fairly dubious assertion.  Other articles made similar, though less stringent assertions:

I contacted several academic accountants with substantial business experience in order to try and resolve this question.  Their responses paint a decidedly different picture than many news or even research analysis might depict.  Also notable is that their responses had slight differences between them.  I have listed my original question to them and their responses, given in the order they were received back to me.

Original Question:

I have heard this repeatedly in several articles about banking or the economy in general: that fair value accounting, or marking to market, was suspended or notably modified at some point between the financial meltdown in the fall of 2008 and the spring of 2009 in order to allow banks to hide losses (although it was never transparently stated that way).  In an accounting class, I recall (hopefully accurately) hearing that while the flexibility in determining pricing already inherent in fair-value accounting was used to full extent by most financial institutions, there was no substantial change to the accounting method promulgated by either FASB or a governmental body or agency.  Notably, there was a press release in late September 2008 jointly by the FASB and the SEC that reiterated the previous accounting methods, with special attention to the current situation, but did not alter it (http://www.sec.gov/news/press/2008/2008-234.htm).  However, I keep hearing the assertion that accounting rules were suspended, changed or otherwise modified.  Moreover, this Bloomberg article from late March 2009 seems to indicate that the FASB did in fact cave to the banking interests.  As Bloomberg  states: “Four days after U.S. lawmakers berated Financial Accounting Standards Board Chairman Robert Herz and threatened to take rulemaking out of his hands, FASB proposed an overhaul of fair-value accounting that may improve profits at banks such as Citigroup Inc. by more than 20 percent.  The changes proposed on March 16 to fair-value, also known as mark-to-market accounting, would allow companies to use “significant judgment” in valuing assets and reduce the amount of writedowns they must take on so-called impaired investments, including mortgage-backed securities. A final vote on the resolutions, which would apply to first-quarter financial statements, is scheduled for April 2.”

So my question is:

  • Did FASB (or some other governmental body) make (or, as Bloomberg article implies, consider making) material changes to fair value accounting methods at some point during the meltdown?
  • If these changes were made, were was their content and implications?

Thank you for any help you can provide on this matter.

Opinion #1:

In my opinion, what are described as “changes” in the below paragraph do not involve rewriting of any fair value standards  . . .

“The changes proposed on March 16 to fair-value, also known as mark-to-market accounting, would allow companies to use “significant judgment” in valuing assets and reduce the amount of writedowns they must take on so-called impaired investments, including mortgage-backed securities. A final vote on the resolutions, which would apply to first-quarter financial statements, is scheduled for April 2.

Instead, the way I interpret the above paragraph relates to how the existing fair value standards are applied.  More specifically, I think what the FASB and SEC are saying is that just because a transaction price is observed, that doesn’t imply that other firms should automatically value their own assets and liabilities via reference to the observed transaction price.   For example, if another bank sells a mortgage back security at a fire sale price, my bank doesn’t have to draw upon that price if I intended to hold a similar security into the future.

Having said that, the FASB did issue an FSP that clarifies when markets are “inactive” and when transactions are “disorderly” – both of which presumably allow a firm to use a “Level 3” fair value.   The following document seems to summarize these things well. . .


Hope this helps!

Opinion #2:

This was very confused, and I’m not sure that I know exactly what happened either, but here is what I THINK happened.

First, this was going on simultaneously in multiple jurisdictions.  The pressure for change was actually higher in Europe (on the IASB) than it was here in the US, and I believe that there were some fairly major changes in IFRS to weaken the role of fair value.  In fact, I believe that the EU may have suspended certain IFRS rulings, with the result that, at least in terms of fair value, there is now an “IFRS” set of rules and an “IFRS-EU” set of rules.

In the US, there was substantial pressure on FASB to water down the provisions of fair value, but FASB has gotten fairly good (through lots of practice) at resisting such pressure.  I don’t believe there was ever any official change to the rules.  What the FASB did do, however, was to issue a number of “interpretations” and clarifications, where they made clear that provisions in the original rules did allow for firms to use judgment to ignore market value when market value wasn’t well defined (e.g., when markets were highly illiquid).  These provisions had not originally been well understood (they were very vague) and so these clarifications probably did change the way in which the rules were applied, even though technically they didn’t change the rules themselves.  My guess is that this is what the Bloomberg article is referring to.  My sense is that the accountants in the US did a pretty good job of NOT caving in, given the circumstances.  I also recall that FASB has several times promised to “review” the rules going forward.  FASB has learned that politicians have short attention spans, and so delaying a decision generally means not having to make a change.

Again, I haven’t studied this carefully – at the level of the courses that I teach, nothing has changed.  So it’s possible that I’ve missed something!

Opinion #3:

The FASB “clarification” issued on April 2 lead to an “easing” of mark-to-market requirements in cases where quoted prices are produced by illiquid markets.

My answer is not based on the text of the FASB’s April 2nd pronouncement.  The FASB is correct to argue that they did not say anything on April 2nd that differs from prior statements.

However, by reemphasizing the role of judgment in the application of mark-to-market, the FASB seems to have reduced the burden of proof on firms that argue against using market prices from illiquid markets.  In particular, the market in question was the market for mortgage-backed securities and the quoted price in question is the family of ABX.HE indices which provide quotes on a variety of portfolios of subprime mortgage-backed securities.

I make this statement after examining the economic implications of the standard with my colleagues.  First, firms were permitted to use the new ruling to prepare Q1 financials.  As a result, Wells Fargo says they reduced reported losses on available for sale securities in Q1 2009 by $4.4B.  But the anecdotal evidence is weakened by the fact the JP Morgan Chase and Citigroup say the standard had little effect. Second, the market price of bank stocks seems to have increased when the new standard was announced.  I say “seems” because the significance of the positive market reaction varies depending which events are included in the measurement period.  In some cases it is insignificant.

The key point seems to be that the rules were not changed, but that FASB tried to run cover for financial firms by stating that it was in their discretion to decide how certain securities and loans would be valued.  In truth, the original rules were so vague themselves that much of it was left to the judgment of companies employing such standards.  Moreover, the primary issue, in my opinion, was not that all of a bank’s securities suddenly had to be valued by some market price, but that certain securities which had, in the past, been accounted for in such a manner, no longer traded in orderly markets and would likely fetch an extremely low price, regardless of future cash flows.  Thus, the crux of Forbes’ article appears overblown—that fair value accounting is somehow equivalent to rat poison for financial institutions—and the talk of an outright suspension of the rules appears groundless: neither FASB nor Congress nor any governmental body revoked the standard.  What does appear to have happened was that FASB, under duress from Congress and financial firms, reiterated its position that companies had discretion in employing the rules, while never changing the wording or content of the rules themselves.

Any opinion expressed here is my own and not that of the firm which employs me.  Under no circumstances should writings or links on this website be taken as a solicitation for an investment or as investment advice.  These topics and commentaries are, whole and entire, for entertainment and discussion purposes only.


2 Responses to “On Mark-to-Market and Its Supposed Suspension”

  1. 1 John Gladney
    November 22, 2011 at 12:01 am

    Awesome article. I am researching this very topic. As I read through SFAS No. 157 I kept asking myself why weren’t these assets being valued based on cash flow? The standard seems very specific about “orderly transactions” and the options available when there’s evidence that the market is not orderly.

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