How the Great Recession Could Have Been Caused by an Accounting Method Mark to market accounting is a method of valuing an asset based on its current market value. It demonstrates how much money a company would get if it sold an asset right now. As a result, it's also known as market value accounting or fair value accounting. It's similar to your insurance policy's replacement value. Historical cost accounting is an alternative method. It maintains the asset's original value on the books. It's the equivalent of insuring your car's depreciated value.
How Does It Work?
A company must report the value of each asset in its financial statements at the end of each fiscal year. Traders who buy and sell that asset type frequently, it's simple for accountants to estimate the market value. The 10-year Treasury note is a good example. An accountant revalues the asset based on the current market rate. The accountant must reduce the value of the notes if the Treasury yield rate increases during the year. The bank holds a note that does not pay as much interest as new notes. The company would receive less money if it sold the bond than it paid for it. Every business day, the value of Treasury notes is published in the financial press. It's worth noting that marking an asset to market is more difficult when it's not liquid. If the asset could be sold, the controller must estimate its value. A home mortgage is an example. If the company sold the mortgage to another bank, an accountant must figure out how much it would be worth. It is contingent on the borrower's ability to make all of the payments.Estimates of Value
A controller can use one of two methods to estimate the value of illiquid assets. The first method is referred to as the default risk method. It considers the possibility that the asset's original value will be depreciated. When applying for a home loan, an accountant will look at the borrower's credit score. If your credit score is low, you have a higher chance of defaulting on your mortgage. The borrower's percentage chance of default would reduce the original value. Interest-rate risk is the second method. It takes into account the asset's value in comparison to similar assets. Let's pretend the asset is a bond. If interest rates rise, the bond will have to be revalued. A bond with a lower return would be less appealing to buyers. This bond, unlike Treasury notes, does not have a liquid market. As a result, an accountant would begin by calculating the value of the bond using Treasury notes. Based on the bond's risk as determined by a Standard and Poor's credit rating, he would lower the bond's value.Advantages and disadvantages
The term "mark to market" refers to a method of determining an asset's current value. Investors want to know if the value of a company's assets has decreased. Otherwise, the company's true net worth may be overvalued. Mark-to-market accounting, for example, could have prevented the Savings and Loan Crisis. Banks used historical accounting in the 1970s and 1980s. They listed the original purchase prices of real estate and only updated the prices when the assets were sold. When oil prices dropped in 1986, so did the value of the property held by Texas savings and loans. On the other hand, the banks kept the value at the original price on their books. It gave the impression that the banks were in better financial shape than they actually were. Banks hid the fact that their assets were deteriorating. When an economy is collapsing, marking to the market is risky. Companies lose their net worth as the value of all assets declines. As a result, many businesses may fail, triggering a downward spiral that exacerbates the recession. The Great Depression was exacerbated by mark-to-market accounting. According to the Federal Reserve, many bank failures may have been caused by mark to market. After devaluing their assets, many banks were forced out of business. President Roosevelt followed the Fed's advice and repealed it in 1938.The Financial Crisis of 2008
The 2008 financial crisis may have been exacerbated by mark-to-market accounting. First, as housing costs soared, banks increased the value of their mortgage-backed securities (MBS). In order to keep the assets and liabilities in check, they scrambled to increase the number of loans they made. They lowered credit requirements in a desperate attempt to sell more mortgages. As a result, they took out a lot of subprime loans. One of the ways derivatives contributed to the mortgage crisis was this. The second issue arose when asset prices began to decline. Banks were forced to write down the value of their subprime securities due to mark-to-market accounting. Banks had to lend less to ensure that their liabilities did not exceed their assets. The housing bubble was inflated by mark to market, and home values were deflated by mark to market during the downturn. The Financial Accounting Standards Board of the United States relaxed the mark-to-market accounting rule in 2009. Banks were able to keep the MBS values on their books due to the suspension. The values had plummeted in reality. The default clauses in the banks' derivatives contracts would have been triggered if they were forced to mark their value down. When the MBS value reached a particular level, the contracts required credit default swaps insurance coverage. It would have wiped out the world's largest banking institutions.How Does It Affect You?
Mark to market discipline can aid in financial management. You should keep track of the current value of your retirement portfolio on a monthly or quarterly basis. It would be best if you met with your financial advisor once or twice a year to rebalance your holdings. Please make sure they're in line with your asset allocation goals. To keep the advantages of a diversified portfolio, this is required. Based on your personal financial goals, an adviser can assist you in determining the appropriate allocation.