Why Mark to Market?

How was I not aware, until now, that what looks like a full RSS feed for Justin Fox's excellent Curious Capitalist blog actually isn't? He didn't write 314 words on the pros and cons of marking to market: in fact he wrote 1,262. And they're well worth reading, as you might expect from the author of a 320-page book on the efficient markets hypothesis.

Fox has a much more nuanced view of marking to market than most of the econoblogosphere, which has tended to knee-jerk dismay at the prospect that the SEC might suspend mark-to-market accounting. Yes, says Justin, mark-to-market is probably better than the alternatives, but that doesn't make it very good: what we really need here is a healthy dose of realism when it comes to the usefulness of any single number.

The health of a bank or any corporation can never be adequately measured by a single bottom-line number. Understanding the assumptions and uncertainties inherent in accounting numbers is crucial to understanding how to use them.

What's more, the old problems with the absence of mark-to-market accounting are not necessarily going to reappear if it's suspended. The S&L crisis, for instance, happened when interest rates rose sharply, and banks which had extended 30-year mortgages at 6% found themselves paying double-digit interest rates on deposits. In Justin's words, they "became what's known as zombie banks, lurching across the landscape running up ever bigger losses," and they were able to do so because they marked their mortgages at par, rather than discounting them at prevailing interest rates.

But what we're looking at now is not a reversion to the state of affairs where banks can stop marking their assets to market and start simply declaring them to be worth 100 cents on the dollar. Instead, they'll mark to a model which not only involves discounting at prevailing interest rates (which alone would have prevented the S&L problem) but also tries to account for expected default rates as well.

Will such models prove more accurate, over time, than market prices? No one really knows. But already we've reached the point at which the markets are displaying a healthy sketpicism about accounting numbers, even when they're generated on a mark-to-market basis. That skepticism was ultimately responsible for not only the downfall of Lehman Brothers (which, remember, was solvent on a mark-to-market basis, or so its balance sheet said), but also the conversion of Morgan Stanley and Goldman Sachs to bank holding companies.

The market has already spoken: it would rather see investment banks regulated by the Fed than trust those banks' internally-generated mark-to-market numbers. If the banks start reporting numbers based on some other standard, trust won't increase at all. But it might not go down much, either.

All the same, the best thing I can say about suspending mark-to-market accounting is that the downside is slightly more limited than some people might think. I still can't see any upside, and I don't think Justin can, either. Given the choice, I suspect that healthy institutions will continue to mark to market -- and that investors will reward them for doing so, and punish those who mark to anything else.