Wednesday, October 01, 2008

About The Mark To Market Accounting Issue

Recently, an increasing number of people, including certain Cato Institute fellows , have suggested that "mark to market" accounting is flawed and that this flaw unnecessarily deepens the current financial crisis.

First, it should be asked what the true value of any asset is for companies. There are actually two possible answers to that question. It is the highest of either the current market value, the highest price anyone is willing to pay for that asset, or the present value of all cash flow that the holder of the asset will receive.

In a neoclassical "perfect market" where everyone have perfect foresight of the future, everyone have equal preferences, where no liquidity problems or transaction costs and so on exist, then this distinction won't be an issue, because under such conditions, the market value will always be exactly equal to the present value of future cash flow. But as we all (except for some neoclassical academic economists) know, real world markets aren't anything like the neoclassical models. And so, in reality there is often a difference between the market value and the present value of future cash flow.

Returning to the principle that true value is the higher of market value or presemt value of future cash flow, it might seem biased that it should always be the higher of the two, but it really isn't. That is because if say the market value of an asset is higher than the present value of the cash flow it will generate, then a company can sell that asset and receive the market value. If on the other hand the present value of future cash flow is higher than the market value, then the company can hold that asset and will in the future receive that cash flow. So, because the company can choose whether to hold or sell an asset and because they will presumably always choose the higher of the two,and then the value that the company will receive will be the higher of the two.

One caveat in this context however is that if the market value only temporarily exceed present value of future cash flow, then using market value for accounting purposes presupposes that the company plans to sell the assets very soon (before the overvaluation ends). If they instead choose to hold on to these assets until the overvaluation ends, then the present value of future cash flow represents true value.

This means that the critics of "mark to market" accounting might (emphazis on might) be right in their assertion that it currently undervalues mortgage backed securities in balance sheets. The high uncertainty about just how much these houses will be worth before the end of this crisis has clearly contributed to a risk premium on these kind of securities, which might eventually turn out to be excessive.

Note that if the critics of mark to market accounting really feel that I am overly cautious when I say mortgage backed securities "might" be undervalued and that they really think this is a sure thing, then I would suggest to them that they should try to invest their savings in such securities, as that would represent a certain opportunity for high investment returns.

A more practical problem with abandoning "mark to market" accounting is that what accounting principle should be used instead? Present value of future cash flow would for reasons stated above be the obvious answer, but this principle has the practical problem that no one really knows how big these future cash flows will be. And allowing companies to themselves estimate how big future cash flows will be clearly opens the door for fraud given the interest they have in manipulating (Like this cartoon strip with Dogbert where he is hired to cook the books, which he does by making unrealistically optimistic assumptions about the future, assuring management that if they implement this then "technically you aren't crooks, just optimists").

Thus, while it might be the case that "mark to market" accounting contributes to an undervaluation of mortgage backed securities, critics of it must first come up with an alternative principle must present an alternative accounting principle which would better reflect the true value of assets, before they can make the case for scrapping it. As the example of Japan in the 1990s show, the strategy of allowing banks to pretend that bad loans really aren't bad loans is not a good one.


OpenID markaddleman said...

Isn't the real problem that a single decision has to be made for all of these financial institutions?

What is the problem with each institution choosing their accounting method providing they disclose that method in their SEC filings? I believe this would let everyone off the political hook for making the decision. Those institutions choosing mark-to-market would almost certainly be demonstrating a higher degree of confidence if their assets than others. Institutions choosing another method would have to justify their decision to their investors.

3:53 AM  
Anonymous hajjen said...

"Present value of future cash flow would for reasons stated above be the obvious answer, but this principle has the practical problem that no one really knows how big these future cash flows will be."

There's also yet another problem: how to determine an apropriate discount rate that reflects the risk of default. That will always be a subjective matter. Any attempts to solve the problem in a scientific way always ends up in phony mathematical models, like the CAPM.

8:00 AM  
Anonymous Zane Liepina said...

I found your blog looking for some expert oppinion about the situation on Latvian/Baltic bank sector which faces much of uncertainty these days. There are a lot of rumour around the market telling that Sweden based banks have a lot of trouble due to situation in USA. There are masses of people already planning to take their money out of Swedish banks, and their concern is based on mass of anonyous sms flying around. I would be very pleased to receive your highly qualified expert oppinion regardin the situation in Latvian/Baltic market which is tumbling and turning those last days. Should there be really expert based concern about the stability of whole Latvian banking sector? Should people realy concider transfering money to some foreign banks? Maby Russia is "a safest zone" now. Is there real concern about bankruptcies of banks in Latvia? I'm interested to those questions not just as a owner of several deposits at Sweden based banks. I'm a half time journalist covering issues that society is alarmed about. And trust me - what is going to happen to banks in Latvia - is topic No.1 last days.
Zane Liepina

9:15 AM  

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