Mark to Market Controversy vs The Laws of Finance
A large part of the mark to market controversy revolves around the fact that mark to market accounting is in direct violation of a fundamental law of finance.
It has long been accepted that when financing assets you should match the term of the debt with the life of the underlying asset. In other words, long term assets should be financed with long term debt and short term assets should be financed with a short term liability.
Mark to market accounting ignores the liquidity of the underlying asset. In fact, in many respects it converts the characteristics of long term assets into short term assets.
Assume that I am going to finance a house. The house should last at least forty years, consequently, I place a thirty year mortgage on it. Unless I sell the house during the thirty years then I should pay off the mortgage. No problem; everybody wins!
However, what if I were to place a short term debt on a long term asset? I would stand a very good chance of losing my investment in a down economy. The same situation holds true for a lender who makes a long term loan secured by a short term asset.
But a house is a long term asset you say! What is a long term asset? A long term asset is an asset whose expected life is greater than one year. In the case of a mortgage it is a loan whose maturity is greater than one year. The problem with mark to market accounting is that you must treat that asset as if it were sold every day. In effect converting the long term asset into the characteristics of a short term asset.
From the banks perspective you now have a long term asset (ie: mortgage) secured by a short term asset (ie: house). The total opposite of what we are taught in the laws of finance.
The bottom line is that mark to market accounting distorts the true economics of the transaction versus reflecting it. Mark to market accounting has to go before the banking community can recover.
It has long been accepted that when financing assets you should match the term of the debt with the life of the underlying asset. In other words, long term assets should be financed with long term debt and short term assets should be financed with a short term liability.
Mark to market accounting ignores the liquidity of the underlying asset. In fact, in many respects it converts the characteristics of long term assets into short term assets.
Assume that I am going to finance a house. The house should last at least forty years, consequently, I place a thirty year mortgage on it. Unless I sell the house during the thirty years then I should pay off the mortgage. No problem; everybody wins!
However, what if I were to place a short term debt on a long term asset? I would stand a very good chance of losing my investment in a down economy. The same situation holds true for a lender who makes a long term loan secured by a short term asset.
But a house is a long term asset you say! What is a long term asset? A long term asset is an asset whose expected life is greater than one year. In the case of a mortgage it is a loan whose maturity is greater than one year. The problem with mark to market accounting is that you must treat that asset as if it were sold every day. In effect converting the long term asset into the characteristics of a short term asset.
From the banks perspective you now have a long term asset (ie: mortgage) secured by a short term asset (ie: house). The total opposite of what we are taught in the laws of finance.
The bottom line is that mark to market accounting distorts the true economics of the transaction versus reflecting it. Mark to market accounting has to go before the banking community can recover.
Labels: accounting, banking, credit crisis
6 Comments:
One does not fix a leaking roof by attacking the building plans with correction fluid.
Fidgeting with accounting rules & financial statements will never fix structural problems. Never has, never will. Ask the Enron guys...
10/10 for ludicrousness on the Long/Short term angle.
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