Understanding basic banking rules is crucial to comprehend the ongoing banking crisis that started in March. One such rule is mark-to-market accounting, which is pivotal in determining asset and stock prices.
Mark-to-market accounting is a simple concept. Every bank or company has a balance sheet with assets on one side and liabilities on the other. The net worth or book value of a company is calculated by subtracting liabilities from assets. The actual market value can be much higher or lower than book value based on investor expectations and other intangible factors.
Mark-to-market accounting uses market prices to value assets. The advantage of this method is that it allows investors to see the real net worth of the companies they are investing in and judge the solvency of banks they are putting money in. However, in highly volatile and crisis situations, valuations can go to extremes, creating a distorted view of solid enterprises and potentially leading to market panic.
Historic cost, another method to evaluate asset prices, is the price paid for the asset when bought. This method helps banks appear solvent during temporary panic conditions. Banks can use historic cost accounting for securities “held to maturity” but must use mark-to-market accounting for securities in a trading portfolio.
Regulatory bodies like the SEC and the Fed apply these rules to specific entities under their jurisdiction or supervision and can create further exceptions. Over the past 25 years, we’ve seen the tension between historic cost accounting and mark-to-market accounting play out.
After the Enron and WorldCom scandals in 2001, companies were accused of using historic cost accounting to cover up losses and defraud investors. This led to a movement towards mark-to-market accounting, reflected in the Sarbanes-Oxley Act in 2002. However, during the global financial crisis of 2007–2009, mark-to-market accounting was blamed for causing financial panic as subprime mortgages crashed in value, dragging banks down with them.
Regulators didn’t abandon mark-to-market accounting but said the “market price” could be based on orderly markets rather than panic markets. This gave banks and other companies enormous leeway in deciding what their assets were worth, and, by extension, what their stock price should be.
The Fed, our central bank, also has a balance sheet. Technically, the Fed is insolvent on a mark-to-market basis due to their long-term notes and bonds. However, the Fed does not mark-to-market. They hold their securities at historic cost regardless of the actual market value.
Commercial banks regulated by the Fed are mostly insolvent on a mark-to-market basis due to their load of Treasuries when rates were 2–3%. With rates now at 5%, their Treasuries and mortgages are 20% underwater. However, banks don’t mark-to-market (except for trading accounts) so the losses are mostly hidden.
Investors should prepare for Stage 2 of the banking crisis by increasing cash allocations and reducing exposure to the midsized regional banks. Be cautious of companies where the market value is greatly in excess of book value, as that premium can disappear quickly in a recession. This slow-motion crisis can become a real-time crisis very quickly.
Let us know what you think, please share your thoughts in the comments below.
