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Mark-to-Market Rules

In April 2009, the Financial Accounting Standards Board (FASB) eased the mark-to-market (MTM) rules, which required companies to report on their balance sheets all their investments (financial instruments, real estate) valued at the current market price (and not the price at which they were bought, or the price at which the company hopes to sell in the future).

The MTM rules have been blamed for the Credit Crunch that we are in today, and also the bankruptcy of several banks. Banks and investment firms held billions of dollars of CDO (Collateralized Debt Obligation) investments. CDOs are complex derivatives that contain U.S. mortgages and other loan receivables. The firms holding CDOs have had to take significant write-downs on their balance sheets owing to the rising mortgage default rates in the U.S., which affected the CDO's value. The market for CDOs also dried up (i.e. low liquidity) following the collapse of the U.S. housing market, which further negatively affected the prices.

According to the rules, when a company prepares its balance sheet and income statement, if an investment that a company holds has fallen in value, then the (paper) loss in value has to come out of the earnings. Therefore, billions of dollars in write-downs have led to billions of dollars in losses for companies.

Is it fair to force companies to take write-downs on their investments even if they don't intend to sell their investments today? What if the company believes that they might be able to receive a higher price in the future when the market improves? In this case, isn't it logical that they should value their investments at prices they believe they might be able to receive for them? These were exactly the arguments the FASB board took into account when easing the MTM rules.

Did you notice that there haven't been a rash of write-downs since April when the rules were eased? I think the easing of the rules was a band-aid solution to the problem. It might lead to major problems later when companies start to misuse the "power" that they now have to value their investments according to what they "think" they might receive for them when they sell those in the future. Obviously, we should expect companies to overstate the value of their investment to "beef up" their balance sheets. Once everyone starts misusing the power, and FASB decides to do something about it (e.g. reinstate the MTM rules), it will lead to another rash of write-downs - and another bear market.

Also, it will now be difficult to compare balance sheets of two companies because they might value the same investment differently. Earlier, at least we knew that if two companies held the same investment, then those would have the same value on their respective balance sheets - even if the prices were artificially low due to liquidity problems or a bear market.

What do you think? Did FASB make the right decision by easing the MTM rules?

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