Sunday, April 5, 2009

Mark to Market Rules Change and Current Market Euphoria

Stock Markets around the world have been berserk with the positive economic news and mark to market rule changes announced by the Financial Accounting Standards Board (FASB). But not many people are familiar with what mark to market stands for and I would like to present my understanding about the same in simple terms. Before I get into it, I request one particular reader whose name I do not want to disclose, not to conceive my article ideas and publish it in another blog with some modifications. It undermines both my hard work and your ability to write on your own. I see the same topics getting published in another blog just one or two days after I post it in my blog which is painful actually.

Mark to Market

Mark to Market is pricing the value of assets based on the current market value and in theory it is as simple as that. But in practice, it is lot messier and in fact can play havoc with the banks ability to withstand as a business entity. If the assets are very liquid and are traded in the exchange on daily basis then, those assets can be very easily priced based on the current market value.

But if the assets are illiquid and are not traded in the exchange on a daily basis, then it becomes more difficult and those assets are not priced based on what the Bank paid initially or what the Bank would get in future but they are priced on the basis of financial models. Perfect example of this is Mortgage Backed Securities (MBS) and readers are very familiar with this term as it has played a major part in the current financial crisis. What are Mortgage Backed Securities?

Mortgage Backed Securities

According to Securities Exchange Commission (SEC), Mortgage-backed securities (MBS) are debt obligations that represent claims to the cash flows from pools of mortgage loans, most commonly on residential property. Let me explain in brief.

Banks and other mortgage institutions give loans to people for the purpose of buying homes. These loans (Debt Obligations) are then sold to governmental, quasi-governmental and other private entities. They in turn pool all these loans and issue securities that depend heavily on the principal and interest payments made by the borrowers who took the loans. When the borrowers default on their loans, these mortgage backed securities become worthless and that’s how Lehman Brothers, Freddie Mac and Fannie Mae, all went down.

Why do banks sell the loans?

Banks sell it to mobilize more capital and it is an easier form of financing than other available options.

Now let’s come back to Mark to Market practices and see how it affects the accounting. As I said, Banks sell these loans as securities. But when the housing crisis began (Loan default), the market for all these securities vanished and the balance sheet of most of the Banks were flooded with worthless mortgage backed securities. Based on the previous Mark to Market practices (Before April 2, 2009), Banks were forced to assess the value of the assets on current market value and Banks had to effectively write off all these worthless securities in billions of dollars from their balance sheet that took huge amount of capital away from them. After all Shareholders equity is the difference between assets and liabilities of a company.

So, most of the banks lobbied with US Congress to ease the Mark to Market accounting practices and on April 2, 2009, FASB announced that Banks can now follow flexible rules with respect to the same. According to FASB, Banks can now value the assets more strictly during good times and with lesser standards during crisis times.

How the Rule Change affects the Bank Stocks?

Based on the FASB Suggestion, if the Banks apply lesser standards, then they will be able to show billions of dollars of more assets in their balance sheets and the stock markets reacted positively to this news. God save investors. Because, this does not really solve the underlying problem of toxic assets. Banks can make their respective balance sheets look better to the eyes but what to do with all these worthless securities? This rule change will not work in long term and masking these toxic assets will again come back and haunt everyone sooner than later. It’s true that US Treasury Secretary Tim Geithner plans to rebuild a market for the assets by handing private investors cheap credit so they can start buying them up but I do not know how many private investors will take that risk of buying extremely risky securities even with cheaper credit from Government.

Conclusion: US Government is taking all kind of actions to kick start the economy. But I fail to understand why they try to mask some of the underlying problems. Sweeping under the carpet will complicate the situation any day and retail investors have to be careful about the stock market movements. In my view, nothing has changed and still there are lots of troubles to be answered. Many small investors feel that they have already missed the bus but I think they will get another chance soon as we have couple of triggers namely Q4 quarterly results and Elections to play spoilsport.

I request the readers to participate in the Sensex 2009 Target poll below.


Praveen April 6, 2009 at 3:18 AM  

I am impressed the way this blog explain content of this complex financial system.... go on

mohd April 6, 2009 at 3:13 PM  

Hello Kumaran
i must say thank you and it is really helpful to understand some complex topics. It is a good article about Mark to market and false euphoria.what do you think about market in near term? thanx

Amol April 7, 2009 at 3:06 AM  

Hi Kumaran
I am always eager to see your posts. Really nice efforts to put this complex topics in layman
terms..Keep it up..

Regarding your current blog, I have some queries..

1. Do banks get a cut by selling loans?

2. In sub prime crisis, these loans were sold many times by many players. So first thing that comes in my mind is why someone would buy a lone. Any comments..

3. Can you please explain what it means by "Banks sell these loans as securities"?

Kumaran April 7, 2009 at 12:43 PM  

Hi Amol,

Thanks for your questions. I will explain it in the next blog.

Viral Rajnikant Dholakia April 12, 2009 at 6:21 AM  

Dear Mr Kumaran,

Can you analyse your bit on 'Indian Textile sector'? Which all companies stand chance to benefit cleanly over longer period, from this laggard sector?

I am asking this query for discussion to all known online blog owners to gauge their response on this lagging sector.

My Textile Picks are: Bombay Rayon & Alok.

Allie July 31, 2009 at 1:26 AM  

The blog is very useful and informative. Marketing people must know all the points given in the blog.

Pro Home Income


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