Understanding Mark-to-Market (M2M) Accounting rules:

Mark-to-market accounting rules have been at the fore front of assault of accountants since the downfall of investment bank Lehman Brothers and the subsequent financial and economic crisis. They have been partly held responsible for the book losses made by the banks, at a time when without it, the losses would not have been visible and given more time for banks to come out of the unholy mess it finds itself in at the present juncture. The other side of the debate is in favour of M2M rules who feel it is an appropriate way to value assets of banks and investment banks too.

Mark-to-Market, as is self explanatory, means the valuation of a particular asset class be arrived at, not based on its historical value, but based on its present market value. Thus the book value of an asset will be different at majority of times from its market value since it would be a function of demand-supply mismatch and other macro-economic factors.

This is the crux of the problem. The crisis, whose signs were visible in May 2008 following the takeover of investment bank Bear Stearns, precipitated into a full blown crisis post September 2008. pundits blamed the M2M rules for the exaggerated loses shown by the banks since they had to mark-to-market the assets which were at an all time low due to the bubble bursting and CDS liability on majority of banks.

Consider a bank with all different types of securities which include bonds, stocks, commodities, hedged currencies and other simple instruments such as fixed deposits, mortgages and credit card loans. The values of these instruments change everyday due to the various selling and buying happening in the market.

Post September 2008, the credit markets froze and there was the liquidity crunch. There were a lot of sellers wanting to sell their doubtful derivative instruments but they did not find any takers. This resulted in the valuation of majority of instruments especially bonds and derivatives taking a beating. They were sold at fire sale prices to distressed investors wanting to buy at discounted prices. Thus the banks had to book losses for instruments which were on its books and post losses. Thus the emperor was without clothes and M2M was blamed for it.

Franklin Roosevelt suspended it in 1938, and the end of the great depression started. Between then and 2007 there were no panics or depressions. But when FASB 157, a statement from the Federal Accounting Standards Board, went into effect in 2007, reintroducing mark-to-market accounting, look at what has happened.