Neal Frankle
Neal Frankle
'Mark-to-Market' in Plain English

What your clients need to know.

April 16, 2009
by Neal Frankle, CFP

Your client's might be asking you about "mark-to-market" and how it's going to impact their investments. If they don't ask, you should tell them anyway because it may be the most significant issue on the table for investors right now.

When you hear people say that "Wall Street greed" caused our current financial crisis they are partially correct but not completely. Politicians did their part too.


In 1938, the government created Fannie Mae. Their role was to create a secondary market for mortgages. This allowed banks to make loans and then sell them so they could make even more loans. This enabled the banks to make more profit and it allowed us easy access to money. Win-win.

In 1968, Fannie Mae was turned into a stockholder-owned entity but not quite a private corporation. They called it a "government-sponsored enterprise."

Over the years, Fannie Mae was granted certain "privileges" and they started making loans in the sub-prime market. The goal was noble — to increase home ownership by minorities — but it obviously wasn't well thought out.

Every politician likes to boast about how home ownership expanded during their time in office. More laws were passed to encourage easy access to money for mortgages.

One of the laws that contributed most to our current crisis was the "Community Reinvestment Act" in 1977. This law basically required banks to make loans in areas where the economics didn't justify it. The banks loaned money knowing that a high percentage of the people who got those loans wouldn't be able to repay them.

In 2004, the government made things worse. They encouraged even more high risk mortgages. As a result, the secondary mortgage market exploded in size.

And if this wasn't bad enough, the Federal Reserve artificially lowered interest rates in the early 2000s. This brought everyone and their grandmother into the real estate market. If you could fog a mirror, you bought a house or two.

Housing Bubble and Burst

This is what caused the housing bubble. The greedy Wall Street bankers, CEOs, loan agents and homebuyers made it worse — but they didn't create the situation. They just exacerbated it.

So what caused the bubble to burst?

Interest rates started rising. Oil prices went through the roof. People got laid off. They couldn't make their mortgage payments. Banks foreclosed and held lots of real estate they couldn't sell. And to top it off "mark-to-market" rules were imposed

This rule required banks to list their assets (mortgages and real estate included) at market prices. Before the rule was imposed, the values of these assets were shown at par value or based on "mark to model") an estimate of the discounted value of the future income the asset would produce).

It sounds like a fair requirement. After all, why shouldn't banks' balance sheets show realistic values? It's a valid point.

But when this rule was put in place, the banks had to determine a fair market price for their mortgages. Of course, all the banks had to do this at the same time. Can you understand why all the banks had big problems simultaneously?

When everyone becomes a seller, what happens to the prices of whatever it is they are trying to sell? Right! The price drops like a rock.

So when this "mark-to-market" rule was imposed, asset values plummeted overnight. What happened next?

The banks' balance sheets looked terrible. Of course they did — a significant portion of their assets had to be written off because nobody was willing to buy the mortgages or the real estate anymore.

Keep in mind that if a bank's balance sheet deteriorates, it runs the risk of being shut down. The government doesn't allow a bank to stay in business if it isn't solvent.

The banks had to improve their financial statements or face being shut down. To do that, they had to raise cash. And they did that by selling other assets — like stocks. So this "mark-to-market" rule resulted in lots of sellers rushing into the stock market at the same time.

When all the banks sold their stocks at the same time, the stock market fell apart too.

You could conclude that a big part of the financial crisis was caused by the "mark-to-market" accounting for illiquid assets.

Last week, President Obama and Congress pressured the Financial Accounting Standards Board (FASB) to support a suspension of mark-to-market accounting. They believe that this will give the banks time to heal their balance sheets without taking down the entire economy in the process.

Do We Have Any Experience With Mark-To-Market in the Past?

Yes we do. This isn't the only time that mark-to-market rules rocked our markets. In fact, mark-to-market accounting existed in the Great Depression. According to Milton Freedman, this caused many bank failures during that time. In 1938, Franklin Delano Roosevelt called on a commission to study the problem and the rule was suspended. Fortunately, President Obama didn't wait eight years like Roosevelt did.

Also, the banks were in a world of pain in the 1980s. They had made loans to Latin America and many of those countries could not repay in a timely manner.

If, in the 1980s, those banks were forced to use the "mark-to-market" rules, every money center in the United States would have been bankrupt. That time, the U.S. government didn't buy up all the debt and we didn't use "mark-to-market" accounting. They allowed banks to keep the debt on their balance sheets at or near par. Eventually, those countries did pay their debts and the banks remained in business.

Going Forward

Many people want to keep "mark-to-market" accounting in place. They argue that current market prices are real prices and that banks should be forced to use them. They go on by saying that showing assets are real market prices forces the banks to be prudent and that's good for our economy. They do have a point here.

But do we have "real pricing" for assets right now? Sheila Bair, current chairman of the FDIC, recently said, "We don't have really any rational pricing right now for some of these asset categories." That being the case, how can anybody fairly value these assets?

At the end of the day you can't argue with the facts. "Mark-to-market" rules torpedoed our markets and economy. They also caused many banks to fail in the 1930's. In fact, we don't have any good experience with these rules in the banking industry.

Suspension of these rules allows banks to use wide discretion in valuing assets. Unfortunately, that's what allowed them to make really dumb loans that got into this mess in the first place. But imposition of the "mark-to-market" rules froze our economy. What to do?

Some people suggest that we re-introduce "mark-to-market" rules gradually. They think banks should use rolling averages over three to five years so the assets would be marked down gradually. We'll have to wait and see what happens with those proposals.

In the short-term, it's reasonable to expect that banks' balance sheets and earnings will improve as a result of suspending these rules. This suspension of "mark-to-market" accounting might have been the most powerful tool the government has used to get our economy back on track — at least over the short-term.


It's in everyone's interest for banks to have fair and balanced financial statements. The problem is that it's almost impossible to define "fair and balanced" at this point in time.

Investors should get involved with this discussion. They should communicate with elected officials and watch what happens in this area carefully. The discussion around "mark-to-market" will likely be one of the most important foretellers of our economy and investments. Would this information be helpful to your clients? Forward this article, they'll appreciate you for it.

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Neal Frankle, CFP, is the author of Why Smart People Lose a Fortune: 5 Steps to Restoring Your Wealth and Sanity. He helps affluent clients establish and implement a safety-net strategy to protect their wealth. He also helps other professionals, such as CPAs, do the same for their clients. If you would like to receive updates on other topics of interest to you and your clients, please register for my free e-mail newsletter here.

The material in this article is general information and not meant to provide specific investment, tax or legal advice. Investing in the stock market involves risk.