Processing Knowledge

Recently there has been a huge hue and cry regarding an accounting practice called mark-to-market. Industry stalwarts like Alex Pollock, former head of the Federal Home Loan Bank of Chicago, say that
mark-to-market accounting fuels a destructive downside. Recently I came across a blog titled “Marked by the Market”, that questions the fairness of the mark-to-market accounting practice

What is mark to market ?

Suppose Alice bought 5 shares of company X at $10, the book value of the shares (depending in the accounting principles) is $50. Now if the stock value trades at $15, then the mark-to-market value of the share
is $75, which is far higher than the book value. However, if the share price fell to $5 then, the mark-to-market value is $25.

What is margin buying?

Other securities are typically used as a collateral while borrowing from a broker to buy shares. This form of buying is called margin buying.

Alice buys a share in company X for $10, using $2 of her own money, and $8 borrowed from her broker. The net value (share – loan) is $2. The broker might set  a minimum margin requirement of $1. Suppose the share goes down to $8. The net value is now $0 (net value ($2) – share loss of ($2)). In this situation, when the margin
posted in the margin account is below the minimum margin requirement, the broker or exchange issues a margin call. Alice will either have to sell the share or repay part of the loan (so that the net value of her
position is again above $1). When the market begins to slide downwards, individuals might start selling their shares to cover their margin positions, thus can result in crashes similar to the ones that happened in 1929.

Impact of mark to market and margin buying.

When even a single company in financial distress starts selling its assets to raise capital to meet regulatory requirements, the market-bottom prices it sells out for become the new standard for the valuation of all similar securities held by other companies under mark-to-market. This results in a downward death spiral for financial
companies large and small. So it seems that the financial analysts and researchers working at S.G
Analytics have identified the crux the cause of financial meltdown in their blog.