Mark-to-Market Accounting and Liquidity

[FarCenter]

http://finance.wharton.upenn.edu/~allenf/download/Vita/Allen-Carletti-MMA-200706-final.pdf


Mark-to-Market Accounting and Liquidity Pricing

Franklin Allen, Wharton School, University of Pennsylvania, [e-mail]

Elena Carletti, Center for Financial Studies, University of Frankfurt, [e-mail]

July 20, 2006

Abstract

When liquidity plays an important role as in times of financial
crisis, asset prices in some markets may reflect the amount of liquidity
available in the market rather than the future earning power of the
asset. Mark-to-market accounting is not a desirable way to assess the
solvency of a financial institution in such circumstances. We show
that a shock in the insurance sector can cause the current value of
banks’ assets to be less than the current value of their liabilities so the
banks are insolvent. In contrast, if historic cost accounting is used,
banks are allowed to continue and can meet all their future liabilities.
Mark-to-market accounting can thus lead to contagion where none
would occur with historic cost accounting.

...

Concluding Remarks

We have shown that if there is mark-to-market accounting there can be contagion
which causes banks to be liquidated unnecessarily. Historic cost accounting
does not suffer from this drawback.

The model presented in this paper was developed in the context of banking
and insurance. It is clear that this context is not crucial for similar
effects to arise. It is the interaction of incentives to provide liquidity with
accounting rules that is key. This can occur in many contexts.
We have focused on one advantage of historic cost accounting compared
to mark-to-market accounting. The debate is a complex one and this is
just one factor among many. If mark-to-market is adopted based on other
arguments, a way of mitigating the potential for contagion is not to strictly
apply this accounting methodology in times of crisis. Rather than simply
declaring institutions bankrupt it may be better to wait until the episode of
liquidity pricing is over.

This paper has considered the private provision of liquidity in markets
and has not analyzed the role of central banks in liquidity provision. In
markets with widespread participation the central bank can provide liquidity
to participants and liquidity pricing will be mitigated. However, in markets
with limited participation, it is likely that central banks may have problems
injecting liquidity that will reach the required markets and prevent the fall
in prices and contagion considered in the paper. The justification used by
the Federal Reserve Bank of New York for their intervention in arranging a
private sector bailout of Long Term Capital Management in 1998 explicitly
used this rationale. The LTCM case was somewhat more complex than the
model analyzed here as in addition to liquidity issues the future payoffs of
assets were also uncertain. However, as we argued above, this uncertainty
about fundamentals exacerbates the problem. Investigating the precise role
of central banks in this kind of situation would be an interesting question for
future research. Similarly, it would also be interesting to analyze the effects
of introducing markets for other assets like loans.

[Warren DeMontague]

1. I'm not a finance guy, but isn't that the same bookkeeping wizardry that Enron used?

Go figure.

[FarCenter]

3. My recollection is that Enron did a lot of other stuff

Like Special purpose Investment Vehicles, to get bad assets off their balance sheets, and on to supposedly "arms-length" entities in the Cayman Islands, Jersey Island, etc.

But it is probably true that they could pump up prices in thin energy markets, which would allow them to mark up options, and overstate their balance sheets.

The problem with "mark to market" goes both ways: it inflates assets artificially during periods of inflated prices, and it depresses assets artificially during periods of depressed prices.

If the institution is planning to hold a mortgage security, and not sell it in the near future, then I think it would be better to value it by adding up the discounted cash flow from expected payments and net proceeds from foreclosures.

[Neshanic]

2. It's the perverse ultimate pile left from "real estate never loses value." EVER.

Real estate agent 2070....

Hi kids, I have a wonderfull house, early 21st Century. It's a steal! You need to see it. Just what you wanted.