By Martin Hutchinson
Contributing Editor

“When I use a word” said Humpty Dumpty in Lewis Carroll’s “Through the Looking-Glass,” “it means just what I choose it to mean, neither more nor less.”

It has always been the ambition of Wall Street to bring its financial statements under a similar type of discipline. And if the The Institute for International Finance Inc.’s new proposal on “mark-to-market” accounting is implemented, Wall Street will have achieved this objective.

Needless to say, that would be bad news for shareholders.

Once upon a time, asset valuation was easy, even for banks. Whatever you paid for it was the value at which you carried it in the books. In the years of inflation, shysters would wander round the country looking for companies that carried their Head Office at its value when built in 1926.

The only exception was in the few cases such as dud bank loans. If the asset was clearly worth far less than you paid for it, then you would write it down to a new lower value. More often than not, you wrote it off altogether and forgot about it. However, if you wanted credit for an asset’s increase in value, you had to sell it – simple as that.

The only exception to this methodology arose in a few trading operations, such as the investment banks – at the time, much smaller – and commodities traders, where positions were written up or down, or in other words, “marked-to-market” at the end of each day, according to that day’s closing prices.  By and large, the only assets marked to market in this way were actively traded shares and bonds.

The advantage of this system for shareholders is that it was difficult for management to play games. There was no possibility of management declaring a higher value for an asset while the company still owned it and paying itself a bonus based on the increase. That’s a big protection, because unless the asset is very liquid or actively traded, it is impossible to be really sure of its value until it is sold.

Banks began to move to mark-to-market accounting in the 1980s. They quickly discovered that it could prove a bonanza for management if there was any kind of profit sharing bonus arrangement, even more so if stock options were involved. In a bull market, it was no longer necessary to sell a building or an equity position to record a profit on it; you could record profits and pay yourselves bonuses as you went along. The technique became particularly profitable when there wasn’t a true market for an asset; in that case management was free to make up a value, using some internal mathematical model.

Naturally, if a bear market occurred, mark-to-market accounting resulted in much larger losses than traditional accounting. First, the value of assets had been marked up to the absolute maximum bull market peak, so they had to be written down that much further than they would have under historic cost accounting. Second, under historic cost accounting an asset whose value was temporarily diminished but was still fundamentally sound did not have to be marked down. Thus share positions, or bonds whose credit rating had become impaired, could still be held at book value. However, under mark-to-market accounting, those positions had to be marked down to their new value and a loss taken.
Story continues below…

Sign up right now, and we’ll send you an important new report for free: “The Three Best Investments in Asia.”

In theory, mark-to-market accounting was more precise in a bear market. In practice, it allowed management to pay themselves bonuses for year after year, and then declare one utter disaster year, in which everything would be written off and most of the profits of the preceding decade would disappear in smoke (without, however, management having to repay the bonuses from the boon years).

Of course in some cases, most notoriously Enron Corp. (OTC: ECSPQ), it was taken too far and the company went bust, but hey, that’s capitalism.

The new FAS157 that came into effect last December did not change much in principle, but codified some of the nastiness. Under it, assets were now classified into three “levels” according to how much of a market there was. “Level 1″ assets had a liquid market – no problem. “Level 2″ assets could be valued by reference to a liquid market in a related asset. “Level 3″ assets had no easily relatable market, and therefore had to be valued by internal mathematical models.

Unfortunately for Wall Street, the new system, which had appeared to offer opportunities for endless bonus-creating mark-ups, was put in place right in the middle of the subprime mortgage crisis. All the collateralized debt obligations with subprime mortgages underlying them became a problem, because the very thin asset-backed securities index or “ABX” market for them collapsed, with AAA-rated bonds being quoted at less than 50 cents on the dollar. That paper, which had all been recorded in Wall Street’s books as “Level 2″ had to be quickly shifted to “Level 3″ – otherwise huge losses would have been taken (huge losses WERE taken; but these would have been even larger).

Fortunately for Wall Street, astute lobbying had ensured there was a loophole in FAS157 – if the market for an asset was a “distress” market without willing buyers or sellers, the asset no longer needed to be counted as Level 2 but could be shifted to Level 3. Naturally the ABX market was a “distress” market – nobody wanted to sell at those prices, and it was highly distressing to management how far prices had fallen.  So the subprime mortgage-backed paper was duly shifted to Level 3, increasing those assets by over $30 billion in one quarter at Goldman Sachs Group Inc. (GS), for example, giving Goldman $96 billion in Level 3 assets, nearly 3 times its capital.

Nevertheless, the idea that prices might have to be marked down sharply in a bear market was unpleasant. What’s more, bear markets could last for years, in which write-down after write-down could occur, wiping out profits year after year and preventing bonuses from being paid. Wall Street lifestyles were seriously threatened!

Now the Institute of International Finance, Wall Street’s tame think-tank, has come up with a solution. Prices should still be marked UP to market, but in difficult times they should no longer have to be marked DOWN to market. In the long run, this would turn Wall Street balance sheets into gigantic collections of waste paper. In the short run, it would preserve profitability and bonuses. And if it all goes wrong in the end, well, as The Bear Stearns Cos. Inc. (BSC) rescue showed, what are taxpayers for?

So what conclusions do we draw? Some possibilities:

• Agitate to have “mark-to-market accounting” outlawed by the Financial Accounting Standards Board. It makes business cycles more extreme, and allows management to play too many games and pay itself too many bonuses. The old system could be gamed too, but not as badly – if you wanted a bonus for an asset’s increase in value, you had to sell it.

• Don’t buy shares of financial service companies with “Level 3″ assets of more than their capital – that’s all the “Big Four” investment banks including Goldman Sachs, Merrill Lynch & Co. Inc. (MER), Morgan Stanley (MS) and Lehman Bros. Holdings Inc. (LEH), and most of the big commercial banks, too. Those Level 3 assets are probably worth very little in a real downturn, because there is no market for the assets and everybody else will be trying to sell them too.

• Expect more unexpected crashes and taxpayer bailouts. The mark-to-market system is highly unstable, and the value of illiquid assets can vanish in a downturn.

• Treat “mark-to-market” accounts with deep suspicion unless all the assets so valued are publicly traded on a recognized exchange.

News and Related Story Links:

• Money Morning:
  Rising Tide of Level 3 Assets a “Disaster Waiting to Happen”

• Money Morning:
  How Wall Street Bankers Helped Create the Current Credit Crisis