Welcome

During the current financial meltdown, media commentators sometimes mention “mark-to-market” accounting” without really stopping to define what this means.

In accounting terms, there’s a concept of financial reporting that encourages assets to be listed on company financial statements at “the lower of cost or market” meaning that assets are to be valued at cost unless the market value of the asset is lower than cost. This principle is age-old, and is intended to present a conservative view of the financial condition of a company.

Banks historically held individual loans in their portfolios (remember that to a bank, loans are assets and deposits are liabilities). Because each loan is unique, it’s hard to determine the market value of that loan, so a loan could deteriorate in quality for some time before the bank was required to lower its value on the financial statements.

When a loan or other asset is lowered in value, the value lost is said to be a “write-off”, “write-down”, or “charge-off.” The amount lost is charged against the bank’s revenues and might be enough to fully erode the bank’s profits and turn them into losses. These losses also require banks to go raise more capital.

In times past, banks had great leeway in obscuring and delaying the recognition of losses in their loan portfolios. In fact, that was the prevalent behavior of Japan’s banks during the 1990s, in part because the culture penalized “losing face” so harshly. So Japan’s banks for years just insisted that loans were worth more than they really were. In financial parlance, this created a “lack of transparency” where investors were simply unable to know what these loans were worth. Part of the Asian financial crisis of the late 1990s stemmed from this lack of full disclosure.

US banking regulations require greater transparency than existed in Japan during the 1990s. However, losses would ordinarily be calculated somewhat infrequently (quarterly, annually), so that banks had time to work through loan problems between periods of calculating and disclosing losses. In the last few years, however, banks were required to implement “mark-to-market” accounting, meaning that each and every day the bank had to assess the value of loans in its portfolio, and each and every day, might be required to make up deficiencies in its capital position.

During a meltdown, mark-to-market accounting is devastating. Because some assets held by banks are securities that have a traded price, a fire-sale of assets at one weak bank causes the price of these securities to plummet. This requires every other bank that holds this security to immediately “mark-to-market” that position, and suddenly even decent banks found themselves short of capital. The spiral feeds on itself, and explains to a great degree how fast some banks have come unraveled.