An Accounting Lesson

At work waiting for my boss again (what else is new?)

Last night I was flying back to New York after attending my sisters college graduation in Nashville. I'm sitting in my seat, reading a book about Boss Tweed and Tammany Hall, when I hear two people in back of me talking about the prospects of a Big 3 bailout. Always interested in listening to the informed thoughts of my fellow traveler, my ears perk up, and although I'm still interested in the "honest" graft of George Washington Plunkit, I'm even more interested in eavesdropping on an economic conversation.

I really shouldn't call it a conversation, it was more like a lecture. The gray-haired Southern gentleman with the charming Tennessee accent was doing most of the listening, and the middle-aged Jewish lady from the Upper East Side was doing most of the talking. It was mostly cliches she was spouting, nothing particularly profound, but then again you wouldn't expect any seering revelations in the coach section of a two hour flight. The gray-haired gentleman mostly just nodded, chiming his agreement ("See, that's what I thought") when the lady paused to seek affirmation. He stared at her intently as she talked about the UAW needing to make more concessions, impressed by her incredible wealth of knowledge almost as much as he was impressed by her wrinkle strewn but blemish free face. She wasn't a looker- but then again neither was he. He leaned over the seat in between them, resting his elbow on the armrest.

She continued on, towards reductions in CEO pay (she was much less adamant about that) and then to the start of the entire mess, the sub-prime mortgages and mortgage-backed securities. The lady even provided a useful anecdote- her idiot cousin who made $18,000 a year got herself a $400,000 house at 1% which then reset to some obscene rate after a year.
"I mean there was fault with the banks (she means mortgage lenders) too, don't get me wrong. But you shouldn't take out a $400,000 loan if you only make $18,000 a year. If people would just be honest on their applications. Besides, it's not like the people who get foreclosed are homeless. They just have to rent, that's all. What's so wrong with renting? I rented for the first... 10 years of my life. There's nothing wrong with renting."

"And then you get to the other problem," she said as the plane skidded on the runway. "This whole, mark-to-market accounting thing."
"Yeah, I heard about that," the gray-haired gentleman said. I was beginning to think that he'd forgotten how to talk. By this time he was probably just figuring out how he could propose before we got the gate.
"Yeah, see we have to get rid of this whole thing because it's not fair. These companies, when they buy the securities, they're not allowed to mark them up when they make money. But when they lose money, they have to take these... these huge write-offs and then they need new capital. See, that's what mark-to-market is. And, and we get in this mess."
By this time we were at the gate and walking to get off the plane. I turned around, with a smirk on my face, while the gray-haired man ate up every single word. They ended up walking off the plane together, all the way to the baggage claim. I got in a taxi before them, but I'm pretty sure they probably got in the same cab and had passionate old people sex in his hotel room.

And oh Jesus Christ in heaven was she wrong. She couldn't have been more wrong if she'd said that the capital of France was Vishnu. I wanted to correct her so bad- but it was quite clear she was running some serious "sound real educated" type game and I have a strict no-cock-block platform. Furthermore, I am proud to say that I'm quite ethical when it comes to that rule.

Then again, she was pretty egregious with her error, so to all you readers I'll give you a quick accounting lesson. The lady made the mistake of mixing up "mark-to-market" accounting with "lower of cost or market" accounting. In current accounting standards, "mark-to-market" is used for things like trading securities while "lower of cost or market" is used for things like inventory. "Mark-to-market" is what it sounds like, you write the asset up or down depending on its value in the marketplace, or if there is not a mature marketplace (as in the case of many OTC derivatives) some reasonable estimate of its fair value. "Lower of cost or market" is valuing something at its purchase price until you sell it, unless the price you can reasonably sell it for is less than the price you paid for it, in which case you write it down to the lower price.

It all comes down to a question of the assets purpose and the primary business of the company. The purpose of trading securities is to take advantage of increases in their value, in fluctuations in the market, at which point you sell them. The purpose of your inventory is to also make you money- but not through increases on the stock market, but through sales to your customers. (Not to mention the question of whether or not you'd have to mark it to the primary/supplier market or the secondary/end user market) Accounting is all about painting a realistic picture of your company, so it needs to be able to adjust for different asset purposes.
Let's say you own a grocery store, and you have a bunch of milk. Under the current system for inventory you keep the milk on your books at the price you bought it for, and then when you sell it you put it on your books as net income. If you had to mark it to market, you'd have to mark to the current price of milk in the primary market. You could make or lose money on commodities fluctuations even if that's not the purpose of your inventory, the purpose is to sell to your customers so they can put some liquid on their cereal. The value of trading securities is completely tied to those fluctuations.
The point is that, the companies that owned these mortgage backed securities DID get to participate in the upside, because every time the price of these securities increased they could put it on the books, and, if they were classified as trading securities, the increases flowed through as Net Income. In many cases, they were far too exuberant in pricing these assets, which led them to have to take massive write downs. Using LOCOM, while not painting the real picture, would have made the writedowns much smaller since they would not have marked the securities up as much.
If you have any questions on the different types of accounting treatments... post them on the bottom I guess. I hope this was as fun for you as it was for me.