Tuesday, October 7, 2008

Mark To Market

Let me start by saying that I am no accountant or financial expert so there is no reason whatsoever to think that anything I say here makes any sense. On the other hand it makes complete sense to me and I can't see how any reasonable thinking person could disagree with what I say. If you know better, please, pretty please take the time to educate me.

I have seen a whole bunch of articles and blogs lately that claim that Mark to Market (M2M) accounting is to blame, or partly to blame, for the bubble that caused our current financial crisis. Some of these call for a suspension of M2M, others call for a ban of M2M, and still others think that M2M is critical and should be left alone.

OK, so what the heck is M2M? Also sometimes called fair market accounting, it is the practice of putting assets on the books at their market value. So if I own 100 shares of company X and those shares are trading at $100, then I would put the value on the books as $10,000. This makes total sense to me. In fact the only thing that doesn't make sense to me is the fact that this is relatively new. M2M accounting rules were only put in place in response to the Enron fiasco. It is crystal clear to me that if I am an investor, I want to see the best possible approximation of the value of the company I am investing in and M2M accounting is the best way to show that real value.

Or at least it is when the assets are liquid. But what happens when you think the market value of an asset is $10,000, but there is no way in Hell that you could sell it to anyone at the moment? Well, that's a problem. It clearly isn't really worth $10,000 in that case. You could only estimate the value by estimating when you could sell for $10,000 and subtracting the associated opportunity costs.

Or what happens if Mr. Market is temporarily insane and wants to pay $10,000 for something that is only really (intrinsically) worth $1000? This is the heart of the argument that M2M caused the bubble. Irrational exuberance caused book values to be hugely inflated, leading to big loans that couldn't possibly be paid back and so forth.

OK, so you need to have M2M accounting in order to tell investors what the real value is, but if you have M2M accounting it can lead to different problems in illiquid or irrational markets. What can be done?

In my opinion, we should just require full disclosure. We should stop letting corporations hide things in spreadsheets that assume that there is a single rational value for all assets. There is not and never will be a single accounting method that is even a vague representation of the truth.

I would like to see assets reported as M2M and cost (price paid) and an estimate of intrinsic value (when possible, perhaps a liquidation value or an arbitrage value), along with estimates of liquidity. If I am a shareholder, then I am an owner of your company and I insist on knowing how you run my business.

Would this prevent bubbles? Of course not. People are intrinsically irrational. But at least you could look at what they did and laugh at them for being stupid.


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