Kahnfusion: Mark-to-Market Meltdown

This is the first in a hopefully occasional series of posts from CCLP's Special Counsel Ed Kahn, on topics ranging from public policy to the economy to politics to the media. Enjoy:

"Mark-to-Market accounting" is much in the news, but few understand the concept. Say an oil company has reserves of 100 barrels. These cost $20 per barrel to find. You could, on the balance sheet, list them as an asset worth $2,000, or if the market price were $50 a barrel, at $10,000. Now let’s say on June 30, 2008, the market price is $150 per barrel. The mark-to-market price folks say, adjust the value to $150 (or $15,000), or perhaps the average of the market for the last three years. Some other folks might pick a lower historical value as realistic, because $150 is seen as a bubble price, but no one is talking of valuing below some long term market price. (The accounting profession has prescribed certain methods and choices to try to assure that all oil companies' assets are valued on a common basis).

Now suppose the market price goes to $10 a barrel or no one is buying all. How should the oil be valued? If "mark-to-market" applies, the $10 per barrel oil would be valued at $1,000. There would be a write-down from the latest earlier value recorded on the books, which turns into a loss on the books.

Change the oil to toxic assets, derivatives, swaps and what have you, and you have the dilemma of the accounting for the banks in a nutshell.

However, please note: if you avoid "mark-to-market" it does not make the banks sounder – something NPR asserted yesterday. It just means the banks have for this day, and perhaps forever, avoided a write-down of asset values. Avoiding mark-to-market does not improve the real value of the banks – it simply cosmetically avoids disclosing the size of the likely loss, and defers the write-down. Allowing banks to avoid write-downs does not make them healthy. It may patch temporarily a leak in the financial bottom of the sinking banks.

--Ed Kahn, CCLP Special Counsel