Relaxing Mark-to-Market Rules Is a Slippery Slope

Mark-to-market accounting is critical to the valuation of profits, positions, net capital and, for that matter, bank solvency.

In keeping with the season, Citigroup on Halloween scared its shareholders and the market by moving another $13.3 billion in assets to the Level 3 designation. Level 3 assets have no active market and need to be valued (either partially or fully) by internal model. The assets Citi moved to Level 3, according to MarketWatch, included asset-backed securities, warehouse loans backed by auto lease receivables and credit card securitizations.

MarketWatch also reported that, according to Citigroup, "$2.9 billion of net additions to those [Level 3] liabilities were offset by $2.9 billion of mark-to-market gains. A portion of the gains was offset by losses recognized for positions classified in Level 2."

OK, let's digest this a bit. So Citi (which probably is somewhat representative) is moving $13.3 billion into the Level 3 category from externally valued to internally valued assets. Included in its Level 3 assets is a profit of $2.9 billion, which was offset by some losses in Level 2 assets.

So, if I get this straight, the internally marked assets are increasing in value while the externally-priced assets are declining? As Dana Carvey's Church Lady would say, "Well, isn't that special?"

Now, I don't want to say that Citi is misrepresenting its financial condition -- I certainly don't have the knowledge or insight to say it is wrong. But it does sound funny that their securities with observable valuations took a loss but their internally modeled positions appreciated.

I don't have an issue with Level 3 assets, per se. The challenge with Level 3 assets is that they are difficult to value. The problem I have with Level 3 assets is that the banks want to expand the use of mark-to-model valuations for more of these products -- embedded in the 2008 Troubled Asset Relief Program, or TARP, is a study of the impact of allowing banks greater latitude in the marking of these troubled assets to model instead of to the latest/last observable price.

This somewhat minor accounting issue is of course not minor at all. Mark-to-market accounting is critical to the valuation of profits, positions, net capital and, for that matter, bank solvency.

Banks are worried that during this credit crisis, securitizations and other real estate derivative assets are being liquidated at fire-sale prices and hence not reflective of their intrinsic or steady state value. Banks maintain that if they needed to mark these assets to market values they would reflect significant and unrepresentative losses, which could impact their solvency.

Now, I am all for bank solvency. In fact, I wrote a scathing commentary criticizing the current Administration for stalling the bailout and getting in the way of bank solvency. However, by softening banks mark-to-market obligations we are fixing a transparency problem (the ability to easily monitor asset-backed securities' collateral value) with a lack of transparency. By not marking these positions to the value investors are willing to pay for these assets, we are compounding the valuation problem that started this whole credit crisis.

I'm sure that Citi and the other larger banks have no vested interest in (artificially) keeping these valuations high (well, er ...) and that bank solvency, compensation and bonuses have no tie to the value of these assets (um, well ...). But the problem with relaxing mark-to-market requirements is that it leads down a very slippery slope. You can start with the very best of intentions, but it gets out of control very easily. A little model tweak, a different reference point, a blind eye -- and eventually we are in a very compromising, or should I say, compromised -- position.

Let's just take our medicine, book some significant loses, use the TARP or whatever to get this toxic waste off the balance sheets, and start anew. That is what our tax dollars are supposed to be paying for. Otherwise, like Japan in the 1980s and '90s, we will drag this problem out for a decade or more and eventually sap the life out of not only our financial markets but our banking system, as well. Let's keep the light on our markets and our valuations transparent. That way the ghosts of the past will stay kiddy lore instead of becoming a very scary reality.