Mark-to-Market Explained

Why do people buy bonds or CDs? Such financial instruments preserve their initial investment (and offer nominal interest as an added bonus). So, if you buy a $10,000 CD that matures in five years, you’re guaranteed to get your money back after 60 months.

Now, do you know you can buy and sell CDs in the secondary market? In fact, the price of these securities fluctuates based on interest rates. So, if you get a monthly bank statement that tracks these price fluctuations, it will give you the impression your CD is worth either more or less than your original $10,000. In fact, that price merely reflects the value of your investment if you sold it right then. If you still plan to hold until maturity, then your CD would always and only be worth $10,000.

Got that? If not, reread until you do.

Let’s move to banks. Banks buy the equivalent of CDs every time they sell a loan (for a house, an auto or whatever). Of course, no one guarantees those loans, so unlike your CD, the bank isn’t sure it will ever get its original investment back. Still, these loans, like CDs, can be bought and sold on the secondary market. If the bank gets a monthly statement of its loan portfolio, it would see the price fluctuate up and down on a daily basis. Yet if the bank planned to hold those loans until they became due, the bank would receive no more and no less than the original value of that loan.

Same thing as before, right? Again, if you don’t get it, read it again.

What is “Mark-to-Market” and when did it start? Mark-to-Market began as a method to protect brokerages and exchanges from getting caught in an unfortunate arbitrage and to make sure margin requirements were met. It made sense. It helped protect investors (sometimes from themselves) and their financial institutions.

But then, corporations began the practice with hard to price assets. This artificially inflated corporate balance sheets in times of rising markets. When those markets went bust, those firms fell into scandal (see Enron). On the flipside, not Marking-to-Market may unrealistically overprice assets in a falling market. It’s a tricky thing where there’s no right or wrong answer about using it…

… except when regulating banks.

Banks have capital reserve requirements, so calculating asset values represent no simple game. It can directly impact a bank’s ability to lend and, as we’re seeing today, to survive. Mark-to-market accounting for banks was suspended from 1938 (hint: what was going on that year?) until 2007 (hint: when did the current credit crisis start?). William Isaac, chairman of the Federal Deposit Insurance Corporation in the 1980s, said during the roaring 80’s, 3,000 banks failed. That was during the roaring 80’s! He adds, “And if we had -- if we had had mark-to-market accounting -- and that's where the SEC requires these banks to mark down marketable assets to whatever the current market price is -- if we had had that in the 1980s, every one of the major banks would have failed, absolutely.”

With mark-to-market accounting, bank lending has been squeezed as the major asset on its balance sheet – real estate mortgage loans – fell in value precipitously. Remember, this is the snapshot-in-time value, not the actual value-at-maturity. But Washington forces the banks to mark-to-market, and the inherent capital requirements mean banks cannot continue lending at the same rate without first getting an infusion of more capital.

Consider the implications: Following FDR might correct the error of Bush. Does this statement call into question my credentials as a “conservative” or does it suggest something far greater?