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Fair Game for Asset Values
Explaining the Mark-to-Market Controversy
If you want to know what a stock sells for, you look at its current market price. That price might be different from what it was yesterday or what it will be later today or tomorrow. But it’s what the stock is worth right now because it’s what you could sell it for. The value of an investment, in this sense, is determined by how interested other investors are in owning it at this moment.
The market price of a mutual fund share is also clear — although it’s determined by the value of its underlying investments and the number of outstanding shares in the fund, rather than by what people are willing to pay for fund shares. Once a day a fund, using a process known as mark-to-market, finds the closing prices of the securities in its portfolio. Then it calculates the fund’s net asset value, which is its per-share price for the next 24 hours.
Futures contracts, which tend to be significantly more volatile than either stocks or mutual funds, are also marked-to-market every day to make those markets more transparent.
The Fairness of a Fair Value Price
In effect, mark-to-market is a widely recognized method for determining the fair market value of an investment. If that’s the case, why do some people want regulators to suspend this established accounting practice amid the current financial uncertainty?
For starters, it helps to know about rule FAS 157, which U.S. government regulators introduced in 2007. This rule requires publicly traded financial companies to report the value of some, though not all, of their assets and liabilities by marking them to market. The controversy arises because the assets that must be marked-to-market are those that either trade infrequently or don’t trade at all, basically because nobody wants to buy them.
If you own something you can’t sell, what’s its value? Often, it isn’t worth what you paid for it. And if you borrowed money to buy the asset, it could be worth less than you owe. That’s the predicament many homeowners face as housing values have dropped and credit has dried up.
This problem of owning assets whose value has shrunk is magnified for financial companies, partly because so much money is at stake. In addition, these companies are required to keep a certain amount of capital on hand to meet their obligations.
If cash is running short — perhaps because clients pull their money out — these companies have to sell whatever assets they can, at whatever prices they can get, to have adequate funds on hand. These fire-sale prices become the new valuation for similar assets that the company retains and for comparable assets owned by other firms.
When these diminished values are reported on a company’s balance sheet, as they must be under the rules, the firm’s financial situation appears significantly less healthy than it would be if the assets’ purchase prices were being reported instead. And the less value a company’s balance sheet shows, the harder it is for that company to borrow, potentially threatening its ability to survive.
To Mark or Not to Mark
Would relaxing or eliminating the mark-to-market rules loosen up credit and help trigger an economic recovery? Advocates of this approach insist that in bad times, assets can be hard to value and harder to sell. Further, they argue that firms shouldn’t have to value long-term assets for what they could be sold for immediately, especially if the companies don’t want or need to sell them.
Opponents of relaxing the rule are equally adamant. They maintain that transparency is essential for a strong and healthy economy and that the current financial problems aren’t the result of mark-to-market rules. Rather, they point out, many of the companies at risk were eager for outsized profits, so they invested in innovative and perhaps fatally flawed products whose true value was never established.
One of the first things you learn as an investor is that you should avoid securities you don’t understand and that a thinly traded product puts you at increased risk. So you may wonder why these investment basics seem to have escaped the notice of so many experienced financial professionals.
Virginia B. Morris is the Editorial Director for Lightbulb Press.