In praise of mark to market accounting

There's a useful idea out there: things are worth what they're worth. No, not what you paid for them, not what you think they might be worth in the future, but what someone will pay you for whatever it is. There's a further useful idea: that the accounts of an organisation should reflect this idea. What is owned by a corporation, a bank, should be listed in the books as being worth what someone will pay for them.

Two little stories about how such mark to market accounting could help solve our current financial woes. There are worried that if Greece defaults then Royal Bank of Scotland will be back for another bite at our wallets and we really don't want that again.

Our peripheral sovereign exposures outside of Greece, which we have already written down to 50 percent, are circa 1 billion pounds ($1.5 billion), which are modest relative to core tier one capital of circa 50 billion pounds.

Well, no, apparently not. For RBS has marked to market: Greek bonds are worth only 50% of face value, so RBS has them in the books at 50% of face value. They've already taken the loss in fact.

However, compare that with Felix Salmon talking about adjusting the principal on US mortgages:

Maybe the thing for the US government to do, then, is not to force Frannie to accept principal reductions outright — but rather just to force Frannie to mark their current underwater mortgages to some semblance of sanity, rather than doing their see-no-evil act and insisting on holding them at par. If Frannie has to take writedowns anyway, then maybe they’ll do so in a homeowner-friendly way.

One way of dealing with the housing problems over there is simply to say, well, yup, those houses just ain't worth what we all thought. So, instead of you having a $400,000 mortgage, we'll say it's now a $250,000 mortgage. Which is of course absurd....except that it's not. For the losses have already happened.

These mortgages were all bundled up into MBS and CDOs recall? Sliced and diced and sold off as bonds. And the people who bought those bonds have made huge losses: so the losses have already been recognised. As Felix points out, when people buy these bonds in the secondary market (ie, at market value) then they can see that there's a profit to be made by making exactly these principal reductions on the underlying mortgages. Instead of a $400k mortgage which is going to default, leaving them with a $250,000 house, why not just cut the mortgage to $250,000 and have no default?

The loss is already baked into the price at which they bought the bond so why not? Which leads us to the problem at Fannie Mae and Freddie Mac. They refuse to mark their mortgages and bonds to market. Meaning that they refuse to make these mortgage adjustments. But we all know full well that the losses have already occurred: that's why they're bust, recall? If they had to mark to market then the mortgage adjustments could be done and the problem would be over earlier.

Remember: we all know the losses have occurred, all we're actually suggesting is that everyone should recognise them. Just as with bankruptcy itself, when losses have occurred it is best to own up to and deal with them quickly. Which is what mark to market insists that everyone does with the benefits we see above.

RBS has already taken the losses of a Greek default: so we don't have to worry about a Greek default (at least, not about RBS). But not marking to market at Frannie means that the US mortgage and housing problems are likely to drag on for years. After all, all that is really being suggested is that accounts and accounting standards should reflect reality: which is what they're supposed to be doing, isn't it?