Mark-to-Market Accounting Likely to Remain

Had the SEC repudiated mark-to-market accounting, it could have set the recovery of our financial sector back a generation. From today's Wall Street Journal story:

Mark-to-market accounting requires companies to value financial assets at their fair value -- the price they can fetch in the market. That has led companies to take big write-downs on thinly traded securities, even if the underlying assets aren't severely troubled. The write-downs have put pressure on prices of financial firms' stocks and forced many of them to sell assets or raise money to stay well above the capital requirements that have been set by regulators.

This "pro-cyclicality" effect has become a worry for financial regulators around the globe. In a speech last month, Treasury Secretary Henry Paulson said regulators must address pro-cyclical aspects of the financial system. "For example, mark-to-market accounting is clearly pro-cyclical. Yet I know of no better accounting method," he said.

Why is mark-to-market a pro-cyclical concept? Perhaps because of the complexity and opaqueness of CDOs, CDO-squareds and their variants, the massive amounts of structured paper that have been distributed globally and the failure of the rating agencies to discharge their responsibilites in a professional and deliberate manner. And let's not forget about the leverage embedded in many now-illiquid structures, rendering the mark-to-market changes that much more jarring in a downturn. With common stocks, exchange-traded options and liquid bonds, mark-to-market changes can be significant but generally don't gap (large, discontinuous, short-term moves) nearly as much as structured mortgage paper and other less liquid instruments. As we've seen in the past year, entire markets can be closed literally overnight once panic sets in. And if you hold lots of securities dependent upon the smooth functioning of these markets - look out.

People need to understand that mark-to-market accounting isn't bad. It's just common sense. It's objective. And it's absolutely essential if the asset owner can't finance its positions on a term basis, like most of the banks, investment banks and hedge funds that got caught napping while their seemingly liquid portfolios went to ice cubes in a nanosecond. Lobbyists, their banking industry employers and their cash have been at the center of trying to get mark-to-market accounting overturned. And it almost worked. This provides a strong argument for why lobbyists are destructive, self-interested guns for hire that serve narrow special interests and not the broader stakeholders.