mark to market

Mark to market accounting allows companies to count as current earnings profits they expect to receive in the future from energy-related contracts.

It was this accounting practice that, in part, brought about the fall of ENRON. More than half of Enron's originally reported pretax earnings for 2000 and a third of its profits in 1999 were unrealized gains based on mark to market accounting.

While this practice is legal, there are no regulatory guidelines delineating how they should be calculated - giving companies wide latitude in their reporting. The lack of regulation is a result of successful lobbying efforts on the part of the energy industry.

Abuse of this accounting method can lead to seemingly large profits, but little or no cash flow (since the actual money hasn't come in yet). Overestimating the value of a contract can necessitate the restatement of earnings, as happened with ENRON. This can mislead investors and cause overly high stock valuations in the short term. Again, see ENRON.

Similarly, the 2001 federal budget was essentially a mark to market proposal. Tax cuts were passed based on future revenue surpluses. Revenue projections have always been known to be little better than guesses and many opposed putting tax cuts into law based on supposed surpluses in the future, but the huge tax cuts were passed nonetheless.

Now, just one year later, opponent's fears have come true; the tax cuts still exist, but the pipedream of neverending surpluses has shattered. Even rosy scenario economists see budget deficits - not surpluses - for the immediate future.

In an earlier era, tax cuts, increased defense spending, and the resulting budget deficits were called Reaganomics. Now, the triumvirate of tax cuts, increased defense spending, and budget deficits ought to be called Enronomics.

In the last few weeks, mark to market accounting has become a key factor in the downfall of AIG, Lehman Brothers, Merrill Lynch, Washington Mutual and countless other household names in the global financial industry. So it's probably as opportune a time as any to learn about what it is.

The concept of MTM is simple: Instead of valuing an asset at the price the company paid for it (book value), a company can instead value the asset at its market value, or whatever that asset would reasonably fetch if it were sold to a third party. This is achieved by periodically adjusting the asset's value to match its market price, and recording the adjustment as a profit or loss of the company.

Essentially, this is the same strategy you are using when you keep an online stock portfolio. If you buy 100 shares of Google at $100 each, your portfolio starts out with a value of $10,000. If the share price goes up to $110, your portfolio's value is naturally adjusted to $11,000 and you have "made" $1,000. Your portfolio value is constantly adjusted to match whatever someone else would pay for your Google shares at any given time.

Mark to market essentially replicates this effect for assets which do not have published values. Usually, an investment bank or third-party analyst is paid some sum to provide a bid or "mark" on a monthly basis, and the owner's accountants adjust the book value of the asset accordingly to match that bid. Investment analysts generally express a mark as a percentage of the original value of the investment; thus a security originally worth $50 which is now worth $45 would be said to be "marked at ninety," or ninety percent of its original value.

The key problem with MTM accounting is that valuation is not a hard science. There are many ways to do it, and no particular "right" way. An analyst can look at sale prices for similar assets, or put together a discounted cash flow model, or ask for sample bids from dealers. Marks are usually not accompanied by an explanation of methodology, and are often in practice quite different from what a rational investor would pay, particularly when the asset is risky (like corporate bonds issued by a company in Chapter 11). Generally, nobody asks; best not to upset the system.

There may be no right way to value an asset, but there sure are a whole lot of wrong ways.

Enron still stands as history's greatest abuser of MTM accounting. Back when Enron was the hottest investment on Wall Street, most of its profits were being generated by creative marking. When Enron set up a new business line -- say, a yak dung futures trading scheme or gamma ray securitization desk -- its accountants would come up with wild and crazy expectations of the business's future performance, discount those enormous expected profits into a present value, and then get Arthur Andersen to sign off on that value as an appropriate mark for the value of the business. The business models couldn't really be questioned because the performance of these businesses was anyone's guess. Investors and consultants never looked closely enough at Enron's books to notice what was going on until the situation was well out of control. When the market caught on to Enron's tactics, the company's astronomical market cap collapsed practically overnight.

Enron's excesses ended up limiting MTM accounting, inasmuch as auditors became more wary of MTM methods and demanded greater transparency. After all, Arthur Andersen went down with Enron, mostly because of its negligence in allowing Enron's book-cooking. But MTM remains alive and well -- well enough to help topple the global financial system in 2008.

The culprit nowadays is marking of mortgage-backed securities and other assets related to the anemic real estate markets. Like Enron's revolutionary subsidiaries, many of these assets were initially booked at totally unrealistic values, thanks to bad opinions from credit rating agencies and bizarre expectations for housing prices to keep rising forever. Once mortgages began to default en masse, many of these securities quickly became "toxic" to potential investors, their market values began to plummet, and since many were being accounted by MTM, those plummeting market values were reflected as losses on the books of banks, hedge funds and other institutional investors around the world. And as recession looms, MTM now stands to impose further losses on these investors by cutting the value of securities backed by credit card payments, auto loans, student loans and other cash flows sensitive to personal incomes -- many of which are accounted for by the MTM method.

The problem which has most recently arose with regard to MTM is that as liquidity has tightened to the level of a choke hold, the market has effectively shut down for many types of big institutional investments, making it impossible to speculate what their market value should be. Now the SEC, FASB and other competent organizations have been forced to quickly scramble together a review of MTM rules and standards in an effort to save the balance sheets of the world's biggest financial institutions.