Friday, December 12, 2008

More arguments against mark to market acounting

I have twice posted arguments against the practice of mark-to-market accounting, here and here.

Now Brad deLong recently posted another concise takedown of mark-to-market practice. If you believe in organizational capital--in goodwill--in the value of the enterprise's skills, knowledge, and relationships as a source of future cash flows--then marking it to market as if that organizational capital had no value is the wrong thing to do.

Especially times in which asset values are disturbed and impaired are likely to be times when the value of that organizational capital is highest.

If you believe in mean reversion in risk-adjusted asset values, mark-to-market accounting is the wrong thing to do.

If you believe that transaction prices differ from risk-adjusted asset values--perhaps because transaction prices are of particular assets that are or are feared to be adversely selected and hence are not representative of the asset class--then mark-to-market accounting is the wrong thing to do.

If you believe that changes in risk-adjusted asset values are unpredictable, but also believe: in time-varying required expected returns do to changing risk premia; that an entity's own cost of capital does not necessarily move one-for-one with the market's time-varying risk premia, then mark-to-market accounting is the wrong thing to do.

There are of course good arguments favouring the continuation of mark-to-market, and many of those arguments are reiterated in the comments section of Prof. deLong’s post. However, I stand by the argument that mark-to-market is a destabilizing force, particularly during times of extreme volatility. It is pro-cyclical, and creates artificial and fleeting capital buffers during times of bullishness, only to take it away, and then some, during bearish periods.

It is detrimental to long-term planning, to long-term financial strategies, or to long-term policy implementation. While it is true that a world without mark-to-market is, arguably, a less transparent world, a world with mark-to-market is a world ripe for manipulation, destabilization, and perhaps, even less transparency. Yves Smith posts about recent bank practices coming to the fore, that serve to sidestep around the original intent of mark-to-market.

What we can use in place of mark-to-market is, of course, the historical cost accounting method, long used before mark-to-market was ever conceived of as an alternative. While historical cost may hide the true liquidation value of securities holdings of financial firms at current mark-to-market prices, a liquidation scenario is only realistically imminent for a few firms at a time.

But in an mark-to-market environment, a liquidation by a single firm can cause a domino effect of forced liquidations scenarios across an entire class of securities, or even the entire financial industry. The capitalist system is already precarious as it is, without having to add more potential sources of debilitating contagion.

Using mark-to-market in accounting for liquid securities is counter-productive, and at best, incomplete. After all, if you really wanted to account for the potentially greater source of instability in the banking industry, you shouldn’t be keeping score on just their liquid securities holdings. Commercial banks, in their regular course of business, mismatch funds when they lend medium and long-term loans to borrowers, while funding/backing these with short-term deposits.

Now, if we were truly supposed to account for complete transparency, shouldn’t we also be requiring the booking of these loans at bank liquidation value? What will that tell us about the viability of banks?

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