Saturday, September 22, 2007

Marc-to-Market in Plain English: Is public company accounting really broken?

In this post, I explain the mark-to-market scheme (or accounting mechanism) in plain English.

Marc Andreessen says - That's it, public company accounting is broken - on how public companies including big banks and brokerage houses are claiming profits on their books by marking down their own debt obligations. Here is what he has to say:

One of the dirty little secrets -- or rather, dirty huge non-secrets -- of Wall Street is that public company accounting has been diverging further and further from cash accounting -- which is to say, reality -- over time.

Over the last several years, a whole series of new laws and rules have larded up income statements and balance sheets with all kinds of fictional, non-cash components to the point that you basically can't conclude much about any public company financial statement you see, except that you really better read all the fine print.

Marc then cites a WSJ article but it was rather complicated so I thought I would illustrate it by using a simpler example. (Let me know if you think I got it wrong or complicated it further!)

3 Players: Anshu, Marc and Bank of England

The game begins: Anshu borrows $1 billion from Marc
  • Anshu borrows $1 billion from Marc. (I am sure he made as much or near about. ;) )
  • On my books - I have a debt obligation of $1 billion - and that is the market value of this debt (since I am totally credit worthy).
  • On Marc's books - he can show assets of $1 billion in IOU's from me.
  • Marc can sell this credit note (from me) to Bank of England for $1 billion, so the market value of the debt is $1 billion. So far, we are all good.
On close of loan:
Anshu: $1 billion (debt owed)
Marc: $1 billion (assets- my IOU)

Didn't Stay in Vegas!

I now go gambling to Vegas with Larry & Bill (you know which ones) and start gambling. I end up loosing lots of money (no one knows how much - kind of, like mortgage companies). So my creditworthiness goes down. (Of course, Moody's will wait for few more quarters before realizing this! ;) )

Marc can no longer sell my IOU to Bank of England for $1 billion, they are not stupid (assumption!). So the value of my debt goes down to say $600 million i.e., the market pegs the value of this IOU at $600 million - in other words, someone like Bank of England would be willing to buy the IOU owned by Marc for $600 million.

In short,
  • Anshu's creditworthiness falls.
  • The IOU's are worth only $600 million in the market.
Anshu: $1 billion (debt owed)
Marc: $600 million (assets - my IOU)

Now, the new accounting rules suggest that I can mark my debt to market i.e., I can claim I only owe $600 million now since that is the value of my debt on the market.

New Rules:
Anshu: $600 million (the value of my IOU, not the debt owed)
Marc: $600 million (assets- my IOU)

Since I have $400 million less debt by new rules, I just made $400 million profit!

The problem is this: I still owe Marc (or the owner of the IOU) $1 billion. A lot of ordinary Americans who have credit card problems are familiar with this- you miss 5 payments on your Citi Card, and the bank sells you to a collection agency for pennies on the dollars. But, you still owe the full amount. Now, in some cases, you can negotiate down the debt but till that happens you still owe the full amount.


Ornithologist said...

Nice example. Presumably, this rule exists to provide a truer account of a company's financial health. It certainly doesn't seem to in this specific case, any ideas of when it actually would (speaking specifically about debt mark to market)?

Puzzling. This works in the other direction as well, dampening profits if their credit rating improves despite the underlying debt and premium paid not changing.

philw said...

> ... in some cases, you can negotiate down the debt but till that happens you still owe the full amount.

So surely you should put the difference onto your balance sheet pending the outcome of that negotiation, rather than writing it direct to profits? I'm not an accountant but even I can tell the difference between free cash and a pending liability ...

Anshu Sharma said...

Yes, Phil. That's exactly what i would do. But then, I am not an expert (who can make up stuff!).

Anonymous said...

Ok Anshu great example.Now the problem here is anshu ability is to pay only $600.His ability to pay $400 is quite uncertain so from a prudence stand point Marc thinks atleast it is better to collect 600 from anshu & forego 400 than to allow keep anshu with his 600 & lose that also. So there is a mark to market loss created.While anshu still has a obligation to pay back marc 400 it is quite uncertain when that event will happen.Now if you change the rule & say an asset likely to realize 600 should be valued at 1000 you are creating a very big systamic risk which can for the moment give you relief but after sometime it will choke you. Marc has to ask himself this question why did he lend to someone who has a habit of gambling his money away, secondly to make his money a small spread between his borrowing & his lending did he expose his complete capital & besides having anshu sink he also is sinking with the bank of england.