May 29

“Mark to Market is Just an Implementation Problem”

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That’s not our quote, but it was Bob Herz, FASB head who noted this at the recent CFA Institute Annual Conference in  Vancouver, B.C, as he laid out a plan for convergence of FASB and IFRS (international accounting) standards.  There are several areas that need to be addressed before this occurs, and mark to market (now required by IFRS) is one of these areas.

We’re all for mark to market of assets AND liabilities…when it makes good sense.

Please remember that accounting is basically sociology…what we group of humans think is the best way to report financial results of enterprises, etc…and these are always subject to change.

And, as we tell all of our clients, when it comes to their investment process, everything starts with what you are trying to accomplish (your company’s key goals and objectives, key performance indicators, etc.).  And, the same holds for accounting…it still comes down to what you are trying to accomplish.

If the goal is to provide a snapshot of balance sheet market values without regard to why those assets and liabilities are on the balance sheet, it’s full speed ahead on MTM — and any problems are indeed implementation problems, per the esteemed Mr. Herz.  However, if the goal is to accurately convey the financial condition of a firm within its unique goals and objectives, MTM only applies where those assets and liabilities are subject to conversion at those values.

For example, insurers typically purchase equities for long term capital appreciation.  When preparing a balance sheet as of a certain date, there is good reason to mark these assets to market, because we all want to know how far along that capital appreciation path those investments are hopefully on.

However, if an insurer puchases a bond to hold for a long period of time (whether for maturity or not) in order to provide investment income (assuming no credit risk), it makes little sense to mark the bond to market, since the bond is being held to support the business/income statement of the company and not to produce outsized total returns.  Conversely, if an insurer actively trades those same bonds, with a philosophy of looking for total return advantages through relative value decisions, etc., than the insurer should indeed mark those bonds to market, because they are less interested in providing income to support the business and more interested in that long term capital appreciation, similar to the investment in equities noted earlier.  It all comes down to something similar to the ‘cash flow statement’ required of companies — trying to determine what the sources and uses of cash flows are.

Of course, market illiquidity has caused getting good market values to be problemmatical, but if one is actively trading, one should know those values or else how could one trade effectively…and if one could not trade effectively, it brings up much more serious issues than what is shown on a financial statement.

Meanwhile, our friends at the CFA Institute, without considering all of their consituencies such as insurance company investment professionals, continue down the path of blindly supporting MTM:

“Putting the blame on fair value for current market conditions is misguided,” said Georgene Palacky, director of the CFA Institute Centre’s financial reporting group. “Fair value is the most transparent method of measuring financial instruments, such as derivatives, and is widely favored by investors. Recent finger pointing seems merely an attempt to shift the focus from the real causes of the financial crises involving sub-prime lending practices and lack of market discipline. Indeed, fair value accounting and disclosures, which provide investors with information about market conditions as well as forward-looking analyses, does not create losses but rather reflects a firm’s present condition.”

Market value disclosures are always a good idea…the more transparency the better is a generally good rule to follow.  However, forcing MTM on investors that use investment grade bonds as a source of income, not total return, is completely missing why those investments are being held.  Alas, MTM is not just an ‘implementation problem’ when you look at insurers.