Sunday, March 29, 2009

'Mark-to-Market' Accounting Practices must stop

The practice of mark to market as an accounting device first developed among traders on futures exchanges in the 20th century. It was not until the 1980s that the practice spread to big banks and corporations far from the traditional exchange trading pits, and beginning in the 1990s, mark-to-market accounting began to give rise to scandals.
To understand the original practice, consider that a futures trader, when taking a position, deposits money with the exchange, called a "margin". This is intended to protect the exchange against loss. At the end of every trading day, the contract is marked to its present market value. If the trader is on the winning side of a deal, his contract has increased in value that day, and the exchange pays this profit into his account. On the other hand, if the market price of his contract has declined, the exchange charges his account that holds the deposited margin. If the balance of this accounts falls below the deposit required to maintain the position, the trader must immediately pay additional margin into the account to maintain his position (a "margin call"). As an example, the Chicago Mercantile Exchange, taking the process one step further, marks positions to market twice a day, at 10:00 am and 2:00 pm.[1]
Over-the-counter (OTC) derivatives on the other hand are formula-based financial contracts between buyers and sellers, and are not traded on exchanges, so their market prices are not established by any active, regulated market trading. Market values are, therefore, not objectively determined or readily available (purchasers of derivative contracts are customarily furnished computer programs which compute market values based upon data input from the active markets and the provided formulae). During their early development, OTC derivatives such as interest rate swaps were not marked to market frequently. Deals were monitored on a quarterly or annual basis, when gains or losses would be acknowledged or payments exchanged.
As the practice of marking to market caught on in corporations and banks, some of them seem to have discovered that this was a tempting way to commit accounting fraud, especially when the market price could not be objectively determined (because there was no real day-to-day market available or the asset value was derived from other traded commodities, such as crude oil futures), so assets were being 'marked to model' in a hypothetical or synthetic manner using estimated valuations derived from financial modeling, and sometimes marked in a manipulative way to achieve spurious valuations. See Enron and the Enron scandal.
Internal Revenue Code Section 475 contains the mark to market accounting method rule for taxation. Section 475 provides that qualified securities dealers that elect mark to market treatment shall recognize gain or loss as if the property were sold for its fair market value on the last business day of the year, and any gain or loss shall be taken into account in that year. The section also provides that dealers in commodities can elect mark to market treatment for any commodity (or their derivatives) which is actively traded (i.e., for which there is an established financial market that provides a reasonable basis to determine fair market value by disseminating price quotes from broker/dealers or actual prices from recent transactions).
SAMPLE LETTER (Cut/Paste & Personalize) YOU CAN SEND/E-MAIL:
March 29, 2009

The Honorable (full name)(Room #) (Name) House Office BuildingUnited States House of RepresentativesWashington, DC 20515

Dear Representative:

I am writing today to inform you of the dangers of mark-to-market accounting and the disastrous effects it is having on our country’s financial system. Instead of focusing on spending trillions of dollars and nationalizing banks, suspending mark-to-market accounting could fix the major financial problems we are facing at no cost.

The history seems clear. Mark-to-market accounting existed during the Great Depression and according to Milton Friedman, it was responsible for the failure of many banks. Franklin Roosevelt suspended it in 1938, and between then and 2007 there were no panics or depressions. But when FASB Statement No. 157 went into effect in 2007, it reintroduced mark-to-market accounting, and look what happened.

At the root of our financial problems are securitized mortgage pools. The price of many of these pools is well below their value based on cash flows, meaning the market is pricing in more losses than have actually, or may ever, occur. Mark-to-market accounting rules force banks to take artificial hits to capital without reference to the actual performance of loans in these pools. This affects our entire economy and undermines the banking system, increasing the odds of asset fire sales and making markets even less liquid.

Suspending mark-to-market accounting is a cost free way to stop this downward spiral and contrary to popular belief will not allow banks to sweep bad loans under the rug. Not suspending it, while allowing massive government interference in the economy is a recipe to undermine future economic growth for years to come. I strongly urge you to ask the Securities and Exchange Commission to suspend FASB Statement No. 157 and mark-to-market accounting altogether.


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