Mark to Market Accounting Reflects Reality

The University of Texas is famous for having the second largest university endowment in the country, behind that of Harvard. Less known is that UT’s second-place ranking is an accounting abstraction.

In truth, for years the overseers of the endowment marked each barrel of oil on the endowment’s books at a value of $2.50/bbl. despite economic realities revealing something very different. So while adherence to accounting rules gave UT the nation’s “second” largest university endowment, no one in the know actually took the ranking seriously.

This is notable now when we consider the controversy over “mark-to-market” accounting. Supposedly the latter accounting abstraction to some degree explains the banking crisis, and the thinking goes that if we merely change the accounting rules followed by the banking industry, firms on their last legs will suddenly be solvent; their renewed lending capacity a source of capital to an economy presently lacking it.

The main argument here seems to be that banks have assets on their balance sheets that can’t be properly valued in what is a “frozen” market for certain securities. It is then said when similarly difficult to value assets are sold into what is an allegedly frozen market that the aforementioned sales force banks possessing similar securities to mark their value down.

And there lies the contradiction. Markets are not frozen as evidenced by the fire sales that supposedly force insolvent valuations on certain banks. There is in fact a market for anything, including what many deem “toxic” securities. Those securities are toxic by virtue of the low value investors attach to them.

So while I can for insurance purposes claim I have a fever as opposed to cancer, if the firm writing my policy does its due diligence, my actual malady will quickly become apparent and this reality will be reflected through higher insurance costs. Banks or any kind of business can mark certain assets to a range of values depending on accounting rules, but diligent investors will quickly to deduce their real value, as opposed to what is assumed by the business pricing the assets.

It’s been said that J.P. Morgan’s fire-sale purchases of WAMU’s assets negatively impacted the financial health of Wachovia for the latter having to mark its assets down. This seems unfortunate on its face, but J.P. Morgan’s purchase merely gave investors a greater sense of the actual market.

If mark-to-market rules in fact did not exist, Wachovia could have used more liberal accounting rules to put a theoretically higher value on its assets. But it seems pure fantasy to assume that investors would have accepted the firm’s assessment of its economic health. J.P. Morgan’s purchase once again provided investors with market information that would have caused them to attach a different, real value to Wachovia’s balance sheet irrespective of accounting.

Looked at from the perspective of Lehman Brothers, City Journal’s Nicole Gelinas noted last week that investors didn’t so much short the firm’s shares because it had written its toxic assets down to zero, but instead they “shorted Lehman partly because they didn’t think that it had written such securities down far enough.” As Gelinas pointed out, Lehman still had assets on its books marked to 70% of original value in a market where Merrill Lynch had recently sold what seemed to be similar assets at “22 percent of their original value.”

If we go back to earlier in this decade, there was a similar accounting debate, though in this case it had to do with the expensing of stock options. Many technology firms that compensate with options lobbied against such a rule for fear that the expense would drive down earnings and earnings per share (EPS). In accounting terms this would certainly be true, but no investor would be fooled by this in much the same way that no investor would be hoodwinked by a stock split that would halve EPS.

In the end accounting is just accounting, and it can in no way exaggerate or downplay a company’s underlying economic realities. We could surely suspend mark-to-market accounting to make banks appear solvent, but if investors have a different opinion when it comes to a bank’s actual health, the more liberal rules will quickly become meaningless.