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Mark to Market and the Crisis of Confidence

by: Mark Sunshine August 28, 2008    

Mark Sunshine

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Last week I had lunch with Marty Schiffman, who told me that “If I live 1,000 years, I will never understand that accounting rule! It’s dishonest!” Marty was, of course, talking about the application of mark to market accounting rules by major financial institutions. Marty Schiffman is not the “average” man on the street; he is the head of the Real Estate Group at Carl Marks and is a senior finance professional. In short, he knows what he is talking about. 

As I have written in several previous blog articles, mark to market accounting is perhaps the dumbest and most misleading set of accounting rules ever promulgated by FASB. In two earlier blogs (here and here) I discussed some of the more inane provisions of these two accounting statements, including the ability of companies to manufacture earnings by pretending that they don’t have to repay their debts. At lunch, Marty told me that bad financial reporting causes a loss of confidence, and that he doesn’t understand why mark to market accounting isn’t transparent. He explained that as the result of the rule, investors practically have to have a PhD in forensic accounting in order to figure out corporate earnings changes in a 10Q.  Marty got really animated (and loud) when he told me that it was dishonest for financial institutions to mark their liabilities to market and manufacture earnings by pretending they aren’t going to pay back their debts. 

Of course, Marty and I agree that the integrity of financial statements and reporting is essential for investor confidence. The US banking and financial systems are based upon “confidence” which, if lost, will tank the systems.

We only need to look at the crisis that beset the US in 1933 to understand what happens when we lose confidence and stop believing. As Franklin D. Roosevelt stepped forward to address the nation in his first inaugural address, a loss of confidence had paralyzed the nation and was destroying the fabric of society.

Below are some of FDR’s timeless words from that famous 1933 inaugural speech which words seem entirely appropriate today:

…[asset] [v]alues have shrunken to fantastic levels…our ability to pay has fallen…the means of exchange are frozen in the currents of trade…the savings of many years in thousands of families are gone..

…Yet our distress comes from no failure of substance… no plague of locusts… the rulers of the exchange of mankind’s goods have failed, through their own stubbornness and their own incompetence…[p]ractices of the unscrupulous money changers stand indicted in the court of public opinion, rejected by the hearts and minds of men.

True they have tried, but their efforts have been cast in the pattern of an outworn tradition. Faced by failure of credit they have proposed only the lending of more money. Stripped of the lure of profit by which to induce our people to follow their false leadership, they have resorted to exhortations, pleading tearfully for restored confidence. They know only the rules of a generation of self-seekers. They have no vision, and when there is no vision the people perish…

…there must be an end to a conduct in banking and in business which too often has given to a sacred trust the likeness of callous and selfish wrongdoing. Small wonder that confidence languishes, for it thrives only on honesty, on honor, on the sacredness of obligations, on faithful protection, on unselfish performance; without them it cannot live…

…there must be a strict supervision of all banking and credits and investments; there must be an end to speculation with other people’s money, and there must be provision for an adequate but sound currency….

…the only thing we have to fear is fear itself—nameless, unreasoning, unjustified terror which paralyzes needed efforts to convert retreat into advance.

Marty understands that accounting rules make a difference, that honesty and integrity are important, and that confidence is being destroyed.  That’s what he told me at lunch.  Why is it that as we enter the second year of the credit crisis, our national and economic leaders do not understand what Marty knows?  Let’s hope that we never again need a President to give another speech like FDR’s inaugural address. 

 

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This article has 2 comments:

  •  
    Aug 28 02:55 PM
    This article highlights a crucial problem. The mark-to market accounting rules assume that assets and liabilities trade in the same markets. Not so! One man's benefit is another's obligation. Benefits are tradable only if they are discounted for non-performance. Obligations are tradable only at a price which allows performance to be assured. The difference is the cost of surety. It is meaningless to talk about trading prices for liabilities unless this is included. The accounting standards setters use arguments that are specious and naive, putting the entire financial system in peril. Society deserves better from such high-priced individuals. For futher reading see Heckman, North American Actuarial Journal, January 2004, and Chasteen and Ransom, Accounting Horizons, July 2007, or email me.
    Reply
  •  
    Sep 23 03:30 PM
    Mark-to-Market Accounting run amok is causing the death of our financial markets.
    Mark to market accounting should be merged with "amortization&quo... concepts when dealing with assets that have a measurable anticipated life span. In other words, if an asset (pool) is expected to have an economic lifespan of 10 quarters, then when its market value increases or decreases by $1,000,000, its book value shoud only be marked up or down by 10%, or $100,000, of the total change during the current quarter. Then, as the expected life span expands or contracts, adjustments to "true up" the previous quarters' markings can be made as a separate line item.
    Having lost a job at a very profitable company that was brought down when FAS 157 was implemented a few years ago, I have personal experience with the havoc wreaked by mark to market accounting.
    Mark to Market Accounting exaggerates gains on the way up and it exaggerates losses on the way down.
    When combined with the ratings industry it is death to any valid measurement of "worth" when dealing with any long-term asset that, when held to maturity, would provide a perfectly respectable average yield over time.
    MARK TO MARKET ACCOUNTING RULES HAVE MADE ALL LONG-TERM FINANCIAL ASSETS INTO UNMARKETABLE "HOT POTATOES" AND FAS 157 SHOULD BE BANNED FROM ANY CIVILIZED SOCIETY.
    Reply
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