Quick history lesson: Mark-to-the-Market was a practice originally begun by futures and commodity traders in the 19th century. Essentially, mark-to-the-market means your holdings must be “priced” every night…at the price they can be sold at.
For years, many bank and investment companies carried investments at cost, or even sometimes at the face value. This never gave an accurate picture of gain or loss.
Today, many balance sheets are filled with untraditional investments, like derivatives (for example, interest-rate swaps). Harder to price, since these derivatives don’t trade every day or carried listed prices (like stocks). So, most companies that own derivatives would come up values on a monthly or quarterly basis…not daily. What happened was companies would come up with a “model” and these assets were “marked to the model” instead of marked to the market.
Fast forward to November 2007.
Financial Accounting Standards Board (FASB) Statement #157 “Fair Value Measurements” became effective in November 2007. This statement was created, partly in response to the Enron scandal.
The bottom line: firms had to value the assets at the price you could sell them for — if you sold them right now on the open market. That’s what something is worth.
And within six months, Bear Stearns checked out. Within one year, Lehman, AIG, Washington Mutual, Wachovia had all succumbed. Merrill Lynch cut a deal.
There is no market for investments like subprime loans. Where there is no information available, the SEC has declared companies can make their own assumption. Which is why many banks and firms may have been extremely slow to write down these assets.
Understand these bank and brokers are not falling apart because your neighbor is in foreclosure. Do you realize that there is good cash flow from mortgage-backed securities…even subprime mortgages?
Under FAS 157, many companies had been forced to deeply mark down (reduce) the value of mortgage-backed securities due to their inability to sell them. This resulted in margin calls everywhere.
In margin-call scenarios, better valued assets get sold, leaving the lousy assets behind. So the lousy equity remains…not fixing the problem.
The SEC is now acknowledging the market for mortgage-backed securities is simply “not orderly” and fair value standards (FAS 157) should be more liberally applied to reflect the expected value.
Suspending mark-to the-market (FAS 157) doesn’t “suspend reality” for the financial sector. The Paulson proposal would replace mark-to-the-market with net operating losses, which would be a very powerful way to help get banks back on their feet…quickly.