Mark to market round up

In an earlier post, there had been suggestions of suspending mark-to-market. Here's a round up of the views thanks to EV. The criticisms of mark-to-market generally seem to follow this line of argument:

We don't know when we're in a bubble so when prices go up we should not suspend mark-to-market. (Fair argument. I'll accept that mark-to-market should not be suspended given we don't know whether we're in a bubble.) The argument also holds in reverse. We should not suspend MTM because we don't know what fair value is in a crisis, so the fair value of the market is the market price. After all markets are rational and reflect all information and is embedded in the prices. Contrary to not knowing when we're in a bubble, I think we know when we're in a crisis. So I reject this argument.

Yes, suspending MTM sets a precedence to the extent that whenever prices fall just a little there will be some lobbying for suspension. But what is the alternative to MTM? I realize that valuing securities is a very different from valuing privately held firms. I work at a privately held firm that is employee owned. Should I not believe the valuations of the accountants just because its stock is not publicly traded? Yes, accountants have been tarnished because of Enron so perhaps the alternative to valuing securities by private accountants should be dispensed with and government accountants might be held in higher esteem. Imagine that - we can actually hold government employees in high regard!

Note that we are not saying that MTM caused the crisis. It is a side effect that can be treated. It won't lead to a cure. For instance, if you have been infected by a virus and have a high fever, do you not treat the fever and let the virus run its course? The argument that is being held by the skeptics is to not treat the symptom (fever) which may make recovery even longer (or at the most more uncomfortable).

The hypocritical calls for not suspending MTM is a belief in markets. If these naysayers are such strong believers in the market process then are these the same people in the financial industry that are crying for a bailout? If they really believe in the free market process then they should believe that the financial industry should be left to battle the ravages of the disease that it spawned with no outside intervention until the disease has run its course. If they believe that the market process is so superior shouldn't they also believe that the destruction that this process has wrought will leave us in a stronger and more resilient if there is no intervention?

I will only quote those who are on my side since I'm feeling particularly partisan today:
Justin Fox: Suspending Mark to Market is for Zombies:
Mark-to-market had its roots in the efficient-market revolution in finance in the 1960s--whose adherents believed that the prices prevailing in the stock market and other financial markets were near-perfect reflections of economic reality. Such thinking soon prevailed in academic accounting circles as well, and the accounting professors began pushing for accounting standards that fit with their new worldview.

The savings and loan mess of the 1980s, which became such a big mess in large part because S&Ls didn't mark their assets and liabilities to market, provided real-world impetus for such a shift. Most S&Ls became insolvent in the early 1980s because of the mismatch between the double-digit interest rates they had to pay to borrow money and the 5% to 6% a year they were earning on the 30-year-fixed mortgages that made up the bulk of their assets. But the accounting standards of the day obscured this grim reality. Some S&Ls--like Washington Mutual--took advantage of the reprieve to trim down, shape up and get themselves out of trouble. Many others became what's known as zombie banks, lurching across the landscape running up ever bigger losses until taxpayers had to put up several hundred billion dollars to shut them down and pay off insured depositors. ...

So in December 1991, the FASB decreed (pdf!) that there should be fair-value accounting for financial instruments. And lo there was fair value accounting for financial instruments! While there have been lots of debates through the years over the particulars of how to implement it, the basic idea had in recent years ceased to be very controversial. The lack of fair-value accounting in Japan and the resulting scourge of zombie companies were often cited, in fact, as key causes of the country's economic stagnation in the 1990s. (By the way, Japanese accounting authorities finally began moving toward mark-to-market last year.)

Earlier this year, though, complaints that mark-to-market was worsening the financial crisis began to surface. Blackstone's Steve Schwarzman was among the most prominent critics. And while much of this talk was self-interested hooey (why wasn't Schwarzman complaining about mark-to-market in 2006?), there was also an important intellectual shift at work. ...

But today I was talking to Gene Flood, a former Stanford finance professor who now runs the fixed-income money manager Smith Breeden Associates, and he surprised me by saying that he is no longer quite the fervent believer in mark-to-market that he once was. "The credit crisis has caused such a liquidity crunch that market prices are not a good reflection of true economic value," he said. "If you are forced to mark everything to market, then you are not getting a good economic picture of the economic health of the institution."

Flood doesn't want to suspend mark-to-market accounting. He just agrees with the new FASB/SEC directions for companies to pay less heed to prices coming out of clearly distressed markets. Paul Miller doesn't have a big problem with this guidance either.

Which leads me to the following conclusions.
First, as commenter That Anonymous Dude puts it, "MTM is the worst form of accounting, except for all those other forms that have been tried from time to time."
Second, investors and regulators and reporters and corporate executives need to learn not to take any financial reporting numbers, whether marked-to-market or not, at face value. 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.

A contrarian view - my comment is to agree up to a point. MTM works in a highly liquid market and yes, I would be suspicious of any company that does not MTM its securities when a market exists. So MTM should not be suspended wholesale but perhaps only in the CDS and CDO market which are OTC where liquidity has dried up.