Marking-to-Market of Debt

I came across an interesting article that discusses the application of a new FASB rule (Statement 159) that permits the marking-to-market of debt. You will recall that marking-to-market is the practice of adjusting the balance sheet valuation of an item, previously only assets, to reflect that current market values rather than the book value or original purchase prices. Well, Statement 159, introduced last year, allows this same practice for liabilities. Considering the declining creditworthiness of the banks, you can imagine what's happened to the yields and prices of the bonds that they have on their books - it's resulted in billions of dollars in illusory revenues.

Why illusory? Good question. Just like marking-to-market of an asset, it represents the accounting adjustment of unrealized gains or losses - this does not represent actual cash flows. The investment banks, having recorded several billions of dollars in such marking-to-market gains, have been quick to offset their losses from the write-down of collateralized assets that have declined to pennies on the dollar. The write-downs, too, are unrealized losses so why then would anyone question this practice? Again, good question.

The difference is in the marketability of the assets or liabilities; put differently, it comes down to whether or not you could actually sell the assets (or buy the liabilities) at the new market price. In the case of the assets, there's no question. There is a market for the CDOs, CMOs and other three-letter depreciating assets that we've come to know over the past year; it's only a matter of price - if it's low enough, then someone will be happy to buy it. The reason is simple: they're marked-to-market based on an expectation (probability) of how much of that asset represents bad loans - the reality may be very different from what the current market dictates and the buyer of these assets could gain substantially from the even a small variance from what is currently predicted. Of course, they're assuming a great deal of risk for that potential.

In the case of marked-to-market liabilities, however, the story is very different. The debt held by investment banks such as Merrill Lynch, Lehman Brothers and other depository institutions such as Citigroup has declined in value as a result of their lower credit ratings, which has caused yields on their bonds to rise and, consequently, their prices to fall. To realize this declining liability value, however, these institutions would need to retire the debt - i.e. buy the debt back from the issuer. The question is, who wants to sell it? Moreover, to do so, these same institutions would need to raise funds, now at a far higher rate, in order to buy the debt, which would increase their actual cash flows going forward. Consequently, no bank will do this and this is why it appears as though an accounting regulation has been twisted in such a way to offer these institutions a paper-out that only leaves analysts and investors like you and me scratching their heads trying to decipher what their financial reports are actually telling them.