Mark to Market Accounting: A Basic Analogy

by | Mar 12, 2009 | Asset Management, Stock Market Comments

How mark to the market accounting helped kill Wall Street

Mark-to-market accounting is what’s used in your brokerage account — your margin account at a Wall Street firm.  To understand mark to market accounting, let’s look at what happens in a retail brokerage account that trades on margin:

Suppose you invest $80,000 in cash in a brokerage account.  You sign up for margin capability.  Before you place a trade in your account, you have the ability to buy up to $160,000 worth of securities with only $80,000.  You will pay margin interest on any outstanding balances, and your “margin maintenance” is recalculated every night – based on the gain or loss in value of the securities in the account.  This is how a margin account works.

Using the above illustration, you have 50% equity in the account, and have an outstanding margin (or debit) balance of $80,000.

Suppose the value of the assets in the account drop from $160,000 to $145,000.  You now have 45% equity in your account.  You still have buying power and seem to be in no imminent danger of a margin call.  Remember, you still owe $80,000.  If you were to close the account now, you would sell the assets for $145,000.  The margin debit balance of $80,000 would be paid (margin interest would also be included).  The securities dropped almost 10% in value (from $160,000 down to $145,000) but you lost nearly twice that percentage, because you leveraged the trade.  You would be left with the remainder… approximately $65,000.

But suppose the value of the assets in the account dropped from $160,000 to $100,000.  You now have 20% equity in your account.  Remember, you still owe $80,000.  At this stage, you have no more “buying power.”   This means you cannot take money from the account, nor can you buy any additional investments.  In fact, at 20% equity you have a “margin call” and your broker would be contacting you requiring you to deposit more money (or other securities) to boost the equity in the account.

Margin works wonderfully when the assets in your account are rising in value.  But margin will wipe you out when the assets in your account are falling in value.

The assets in the account are repriced every single night in a margin account.  And the equity is calculated every day and the amount needed for “margin maintenance” is also calculated every day.  And when your account gets upside down, you have a margin call, and it needs to be rectified right away.

Margin accounts are calculated using mark to the market accounting.

Banks (and brokerage firms) that own mortgage backed securities have been required — since November 2007 — to use mark to market accounting on these securities.  Coincidentally, this was just around the time these mortgage securities started dropping precipitously in value.  2007 saw many mortgage firms get wiped out, and brokerage firms and banks holding these assets started realizing the volatility of these assets.

Remember banks and brokerage firms were required to employ mark to market accounting beginning in November 2007 for mortgage backed securities.  As real estate values collapsed, and foreclosures began to rise, banks and brokerage firms no longer wanted to hold the securities as investments on their books.  It is no wonder then, that six months later (March 2008) that one of the biggest holders of mortgage backed securities — Bear Stearns — was caught in a massive credit squeeze.  The assets that they regularly borrowed against were no longer “borrow-able.”

Bear Stearns — which had traded at well over $100 per share months before, agreed to sell themselves to J.P. Morgan Chase for two dollars per share.  This figure was ultimately increased to $10 per share.

By mid– 2008, Merrill Lynch had decided to unload a $31 billion pool of mortgage backed securities that they owned, and essentially announced they would take the best offer.  These mortgage backed securities had been held on the books (it’s estimated) at $.80 on the dollar.  This pool was sold for $.22 on the dollar in July, only after Merrill Lynch agreed to subsidize part of the losses that might be incurred by the buyer.

These are anecdotes and examples using vast over-simplification and are being used to illustrate how mark-to-market accounting works.
While not directly connected, mark to market accounting required that other banks and brokers investing in similar type investments market their own similar assets down to similar levels.  Thus, the entire mortgage backed market froze. Trades were no longer taking place, because every time a trade would take place, it would require the values of similar securities to be repriced everywhere.  These securities could no longer find a value and could not be borrowed against, hampering most lending capabilities at these firms.