From Liquid to Antiques Roadshow

Story Highlights:

• Mark-to-market is an accounting standard that means an asset's value should be determined by the current price it garners in an open market.
• Some assets, like stocks, are easily valued and highly liquid; while other assets, like art or certain kinds of financial instruments, trade less often and thus are more difficult to price.
• Mark-to-market isn't a new phenomenon, but with recent regulatory crackdowns, the range of assets it applies to has grown.
• FASB Statement No. 157 may have been too strictly interpreted by accountants—prompting complaints from many and a new interpretation by the FASB on Wednesday.

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Impassioned debate continues to rage across the country—leaving many wondering who's to blame for tracking financial mud across our nice clean fiscal floor. As Washington deliberates, many ponder whether government intervention is needed in the first place. After all, couldn't imperiled Financials survive (or even have survived) if allowed to revalue their so-called toxic (and difficult to appraise) debt-based assets?

Here's a little background on the complicated and (until recently) obscure topic of mark-to-market accounting. Mark-to-market means an asset's value should be determined by current market activity. Think blue chip stock prices—millions of shares in a single company trade each day. A large, liquid market (read: lots of willing trading partners for fast transactions on demand) easily determines an equilibrium price. Investors know if they sell today their shares are worth that widely quoted price. The value of a blue chip stock investor's assets and financial viability are pretty transparent, accurate, and easily determined.

But not all markets are big and liquid. Many things trade sparsely—like art or collector's items. Consider PBS's Antiques Roadshow: When an appraiser values a rare Civil War coin collection, they must rely heavily on the last time a similar item sold at auction. A piece's condition or the story behind its acquisition may also figure in the appraisal. How such an asset contributes to the owner's current financial condition is murky at best.

Much of today's financial trouble arose when housing declines froze mortgage-backed securities markets. Those securities moved from the first asset class (pretty liquid and easily valued) to the second asset class (Antiques Roadshow) virtually overnight. In the fantastical and exhilarating world of financial accounting (OK, not really), the Financial Accounting Standards Board (FASB) denotes these categories as Level 1 and Level 3 assets (Level 2 is an amalgam). Level 1 is easily valued by a large market, while Level 3 lacks any market to determine value at all.

Mark-to-market accounting isn't a new phenomenon. Firms have marked certain assets at fair market value for years. What changed more recently was the range of assets subject to such rules. After the Enron scandal revealed how easily sketchy accounting practices could hide balance sheet health, regulators pushed for stricter oversight. This meant mark-to-market wouldn't just apply to Level 1 assets but to more illiquid assets also. During good times the requirement posed little problem, and firms were mostly allowed to use their own models to determine the value of illiquid assets.

But last November, in light of several months' financial trouble, the now infamous FASB Statement No. 157 attempted to set a new standard for valuation. Many accounting firms interpreted FASB 157 to require they value illiquid assets using whatever market prices they could find—oftentimes this meant emergency prices set by failing firms. As more and more folks complained this was unfair and inaccurate, the SEC and FASB released an "interpretation" of the rule allowing accountants to ignore "distress sales" for reporting purposes.

Whether mark-to-market accounting has helped or hindered financial institutions is under intense debate. There are vehement arguments on both sides. After all, that the assets were to some extent losing value is true, and many believe mark-to-market simply helped turn on a brighter light. Others say the rules have made the crisis worse than it would have been and amount to esoteric accounting nuance. Whatever the final conclusion, it's an issue that deserves our attention—especially given the size of the government bailout currently being debated.