MainStreet Explains: Mark to Market Accounting - TheStreet

If you’re following the financial markets these days, a common phrase you may have heard or read is “mark to market,” which may have left some scratching their head. With the volatile markets or, shall we say, stalled or stagnant markets understanding what is meant by mark to market activity is more important than ever. Expect to see the term more as congress debates a bailout plan that is a tool to “re-establish market place and start to free up the institutions to trade with each other, says Martin Evans, a Professor of Finance and Economics at Georgetown University.

MainStreet spoke with Evans to define “mark to market” and tell us why we should care.

What does Mark to Market mean?
If a company, whether it’s financial institution or a bank, buys a financial asset they have that asset on a balance sheet. But, the price on the balance sheet changes [depending on the markets]. The question is: How should that be reflected? If the price goes up, then the balance sheet should reflect that, and similarly if the price goes down, then the price should be reflected. This process of looking at how much you could sell the financial asset, i.e. stocks, bonds, or derivatives for [based on the market], is called mark to market.

Why should you care?
This is extraordinarily important because in the world’s banking industry financial institutions have stopped trading lots of the bonds that they usually trade with one another. The only circumstance when [trading or selling] is taking place is if an institution is desperate to sell. And, so the buyer knows that the institution is desperate to sell, so the financial institution buys them for a lot less then a normal market levels. That’s a problem because under the accounting rules, the prices for which those transactions are sold are reflected in the balance sheet of the financial institute if they have similar assets.

For example, suppose an institution would only buy bonds from another institute at 20% below, now there is a 20% lower transaction, and once that takes place you have mark to market, then every institution that has similar assets has to mark down the prices. Think of all the bonds related to the housing sector in the U.S., banks have stopped trading them, and the very few taking place are extremely low because the only people selling are those trying to get anything for them, and when that happens, and everyone marks to market to reflect those true assets the value plunges. This leads to a deterioration of the balance sheet.

Why is mark to market currently a problem?
[There’s] a problem using mark to market when the market doesn’t work. It’s a great idea if there are a lot of transactions. When the [ market] stops working and there are very few transactions the prices do not reflect market prices but the specific needs of the few buyer and the sellers. There in the nutshell is what’s going on. The markets dried up and few and fewer people are buying and selling, the remaining sells are even more depressed prices and the only people that would buy are the people offering next to nothing. Right now, there are no prices out there to compare against. They have nothing to benchmark it against to reflect market based prices.