The credit crunch-Mark it and weep

Mark-to-market accounting hurts, but there is no better way

WITH memories of their drubbing in the dotcom bust still fresh, accountants have kept their noses clean in this financial crisis. Once again, though, they are being dragged into the fray. That is because they are enforcing fair-value accounting, in which assets must be marked regularly to the market price: that is, what they would be expected to fetch right now in a sale. Regulators and bankers fear that this “mark-to-market” approach is helping to turn a  ①(phrase) into a solvency one. As holders of mortgage-backed securities and the like revalue their assets at fire-sale prices, they are running short of capital—which can lead to further sales and more write-downs. Are the beancounters ensuring a crash?

②(sentence)  It is timely and transparent, but when markets collapse, prices become less reliable. How do you mark to market when there is barely any market? Some firms rely on credit-derivative indices, but these are far from perfect proxies (see article). Others  ③(phrase) internal computer models, but their accountants are cracking down on them. Banks are also being asked by their auditors to put more assets into the fair-value regime's lowest bucket (for the most illiquid assets). This adds to their woes, since such assets carry a higher capital charge.

Regulators worry that mark-to-market may create a “liquidity black hole”. Nerves jangle at every fire-sale, for fear that this will become the new benchmark for sticky assets. The fear is that value-at-risk systems force investment firms and banks to offload securities, leading to price falls and further sales. ④(sentence)  The result will be excessive write-downs—as the stable value of assets is above today's distressed level.

That is a damning list of failings. And yet, for all its pain, fair-value accounting is still the best way to value businesses. Especially if investors and regulators treat accounting rules sensibly: as a measuring stick, not a source of universal truth.

On that score the old system of historic-cost accounting was worse. In a crisis prices fall until bottom-fishers start to buy. Yet when assets were booked at their original price, rather than the market one, banks could delude themselves—and investors—that dross was gold. Under historic-cost accounting, the banks had every reason not to restructure assets, because that meant owning up to their losses. Look at Japan, where the economy was sunk for most of the 1990s by stagnant loans to “zombie” companies. Historic-cost left investors in the dark about valuations; it was also prone to fraud and fraught with  ⑤(phrase), since sloppy lending went unpunished.