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Mark-to-market makes a mess.

Byline: David Jones

As Washington regulators and Wall Street investors grapple with frozen credit markets, a fierce debate rages over an accounting method that some critics blame for the near collapse of the nation's banking system.

Critics charge that so-called "mark-to-market" accounting -- also known as fair value accounting -- has forced banks to write down billions of dollars in assets that are considered nearly worthless in a frozen market. It's a strategy critics fault for much of the dismal condition of Wall Street.

Mark-to-market, which is used all the time in the trading of New York City buildings, essentially requires that lenders assign a value to an asset based on its current market value, as opposed to a more traditional hold-to-maturity model that uses historical income and other criteria for valuing assets.

"When they talk about toxic assets, what they really mean is they have assets on their books for which there is no market," said attorney Mark Fawer, chairman of the real estate department at the Dreier law firm in Manhattan.

Real estate investors often use mark-to-market accounting -- which lawmakers are now looking to reform -- to assign a value to assets based on what the property could command on the market if it were sold today.

For example, when Boston Properties acquired the General Motors building for a record $2.8 billion in June, it assigned a value based on the current market rents for the building as opposed to the actual rent being generated from existing tenants. The company noted that the average rent being paid at the GM building was $90 a square foot, which it said was half the current market rent of $180 per square foot.

"The magnitude of the mark-to-market at $90 a square foot was a critical factor in our decision to purchase the GM building," said Mike LaBelle, chief executive of Boston Properties, during the company's second-quarter conference call. "Over time, we believe we will see growth in market rents and capture significant growth in current income and appreciation."

He said that Boston Properties would realize a $1 billion mark-to-market adjustment once it accounts for the difference between current rents and market rents.

Mark-to-market accounting gained a foothold in September 2006, when the Washington-based Financial Accounting Standards Board issued new guidance for valuing assets, known as FAS 157. The standard of valuing assets has been used in Europe for many years, and was designed in part to establish a uniform method of how to measure the value of assets.

Under the guidelines, there were three different levels used to value an asset:

* Level 1 assets are used to measure assets that have specific market data, like stock prices, to determine their value.

* Level 2 assets are used to measure assets that have a comparable measuring stick. A Class A office building in the Financial District, for example, could be compared to a similar building in the same submarket.

* Level 3 assets include assets where there is no direct comparison. Very often, they involve collateralized debt obligations for a bucket of subprime loans.

Among major U.S. banks and other financial institutions, mark-to-market is used to value collateralized debt obligations and mortgage-backed securities. Banks are required to peg the value of these assets on a quarterly basis, even if there is no intention to sell them.

Critics charge that the existing mark-to-market system forced lenders to write down the value of those securities when the markets dried up, and there was nobody willing to buy these assets.

"With mark-to-market, right now, there is arguably zero market value for a lot of the toxic mortgages sitting on the balance sheets of various lenders," said Jonathan Miller, president of the appraisal firm Miller Samuel.

In May, Merrill Lynch, which has since been taken over by Bank of America, reported that its Level 3 assets, which mainly consisted of hard-to-value commercial mortgages and other assets, rose nearly 70 percent to $82.4 billion. In July, the now-defunct Lehman Brothers reported $41.3 million in Level 3 assets, which comprised 6.5 percent of its total assets. By September, the weight of its toxic investments proved to be too much, and Lehman collapsed in a massive bankruptcy filing.

Martin Sullivan, former chief executive of AIG, blamed mark-to-market rules for the company's near collapse in September, when an $85 billion taxpayer bailout was required to support the declining value of the company's credit default swaps.

"When the credit markets seized up, like many other financial institutions, we were forced to mark our swap positions at fire-sale prices as if we owned the underlying bonds, even though we believed that our swap positions had value if held to maturity," Sullivan testified before Congress. "The company nevertheless began reporting billions of dollars of unrealized losses on the basis of then-current market valuations."

As a result of the Lehman and AIG debacles, the FASB issued new guidance on how lenders can use mark-to-market accounting. The rules would allow lenders to use assumptions of future cash flow as an alternative to assuming the value at a "fire-sale" discount.

The Securities and Exchange Commission has proposed a comprehensive study to determine its role in major bank failures.

A majority of industry officials say that mark-to-market is the most accurate method of determining the value of an asset. They say critics of mark-to-market are using the rule as a scapegoat for risky investing.

"In many ways, the attack on mark-to-market accounting is as much as anything a scapegoat because accounting standards don't talk back," said David Larsen, managing director of the San Francisco office of Duff & Phelps and head of the company's fair value measurement advisory practice. "It's been much maligned in the press as a proxy by people who are upset about other things."

John Ross, former chief executive of the Appraisal Institute, said, "We tend to believe the concern over fair value accounting is a straw man."

"The bottom line," said Ross, who is also a senior advisor for RICS Americas, the U.S. arm of the Royal Institution of Chartered Surveyors, "is even if the market becomes very illiquid, any manager of assets really should be aware of what the underlying value is of those assets. It is the most economically efficient basis for reporting an asset."
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Title Annotation:mark-to-market accounting
Author:Jones, David
Publication:The Real Deal
Geographic Code:1USA
Date:Nov 3, 2008
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