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Mark to Market Accounting as a Magnifier of Financial Crises

Nemanja Stanisic

Snezana Popovcic Avric

Vule Mizdrakovic

Marina Djenic

Abstract

The main objective of this paper is to provide an analysis on whether mark-to-market accounting magnifiesfinancial crises. Even though the results of numerous studies on this topic offer various conclusions, the majority

of them conclude that fair value accounting, or mark-to-market accounting, does not cause financial crises. Moststudies that had similar conclusions dealt with the 2006-2008 period, whereas we focus our research on periodfrom 1881 to present day. Primarily, we will point out the historical context of the implementation of mark-to-market accounting and consequences it had. We consider the long term relationship between United States(U.S.) GDP and the S&P 500 index values and key historical developments to conclude that implementation ofmark-to-market accounting contributes to creating of asset bubbles and assets overestimations. Even thoughmark-to-market accounting does not cause financial crises, it does magnify fundamental procyclicality which isinherent in efficient markets.

Keywords: financial crisis, mark-to-market accounting, procyclicality

JEL classification: M 41, G 01

1. Introduction

For the last forty years we had more financial crises, since the end of the Bretton WoodsInternational monetary system in 1971. It is valuated that in U.S. the subprime crisis alonesince 2007 resulted in an 8 trillion dollar loss in share values. Crises are a product of powerfuleconomic and non-economic forces; however, when a financial crisis emerges there are somefactors that may make it stronger and increase its impact and duration. In decision making,

business and especially accounting, faster and more available solutions may not be the safest,or the most fitting. In order to increase liquidity, residential mortgages were packaged infinancial instruments and resold in the process of securitization, while at the same time beingsold short by the same institutions that were promoting them. These instruments were also

provided with high rating by the three largest credit rating agencies. Mark-to-marketaccounting has been used to disclose income in financial statements sooner and withoutmarket verification. Assets have been revaluated upward, but the problem with revaluations isthat when write-offs occur they tend to exceed write-ups (Solomon, 1936:9). These write- PhD, Singidunum University, Faculty of business in Belgrade, Danijelova 32, 11000 Belgrade, Republic of

Serbia. Phone: +381 11 3094 046. E-mail:nstanisic@singidunum.ac.rs PhD, Signidunum University, Faculty of economics, finance and administration, Bulevar vojvode Misica 43,

11000 Belgrade, Republic of Serbia. Phone: +381 11 30 666 70. E-mail: savric@fefa.edu.rs PhD, Singidunum University, Danijelova 32, 11000 Belgrade, Republic of Serbia. Phone: +381 11 3094 038.

E-mail:vmizdrakovic@singidunum.ac.rs (corresponding author) MSc, Singidunum University, Faculty of economics, finance and administration, Bulevar vojvode Misica 43,

11000 Belgrade, Republic of Serbia. Phone: +381 11 30 666 70. E-mail: mdjenic@fefa.edu.rs

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downs are a reflection of the obsolescence not accounted for by depreciation. As a result,revaluations have an impact on capital and income. However, it seems that it has been cleared

by many authors and by the Securities and Exchange Commission (SEC) that mark-to-marketaccounting didnt contribute to the financial crisis of 2008 and fall of many financialinstitutions. Nevertheless, in its defense, SEC and many authors noticed and pointed out that

investors never complained when mark-to-market accounting increased their earnings, butreacted when the opposite occurred. There has been a growing consensus to revise the U.S.Generally Accepted Accounting Principles GAAP, and as a result the SEC has been obligedto condone the analysis on whether mark-to-market accounting played a significant role andcontributed to the financial crisis. The aforementioned study concludes that this method is notresponsible for the crisis based on the following fact which is related to financial institutions:The results of this analysis illustrate that the adoption of SFAS No. 157 and SFAS No. 159did not have a significant impact on the percentage of assets that were measured at fair value,which changed from 42% as of year-end 2006 to 45% as of first quarter- end 2008 (SEC,2008:57). The effects of this change in accounting however did not start in 2006, but muchearlier in 1993. In order to come to a logical understanding of the implications of the changein accounting principles, it is necessary to continuously analyze the entire period stemmingfrom it. We therefore define the main hypothesis of our investigation: Mark-to-marketaccounting has through the history of its use magnified the effects of financial crises. We alsonote that the FEDs regulation and maintenance of artificially low interest rates played a largerole in the creation of the crisis in the first place, but we take this fact as a constant in ouranalysis of this problem. Having in mind that many authors mention in their research thatmark-to-market accounting has been invented just recently and that its implementation beganin the seventies, we will first provide historical information on the implementation of thismethod and its legislation.

2. Literature review

Significant number of scientific papers can be found that debate the role of mark-to-marketaccounting in financial crises. This fascination does not fade even though it has been almostfive years since the first effects of the current crisis. Most authors (like Shaffer, Scott, Lauxand Leuz) came to the conclusion in their findings that fair value accounting had little or noeffect on financial crisis occurrence and its amplification. However, Wesbury and Stein intheir research from 2009 point out that mark-to-market accounting rules affect the economyand amplify financial market problems. As two main stabilizing factors of the financialmarket they note: time and growth. By using this rule of asset valuation we lose time because

the market is pricing in more losses than they have actually, or may ever, occur. Further, theynote that decreases in capital by write-offs increase the possibility of asset fire sales and makethe market even less liquid. The authors indicate that during the crises in the 1980s and the1990s the absence of mark-to-market accounting gave banks time to work through problems.

Although fair value accounting has been implemented for a quite some time, there is a lack ofguidance in studies on fair value determination and practice. Some authors like Dorestani etal. in their research from 2011, claim that out of 201 randomly selected universities of allregions of the U.S., there is no single university offering any stand-alone courses or programsof fair value accounting. Likewise, most authors conducted research proving whether fairvalue accounting was the main cause of financial crisis occurrence, as opposed to a

contributing factor. Nonetheless, it seems clear that financial crises are created due to

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numerous factors and the real issue with fair value accounting lies with the fact that it mighthave magnified previous and may magnify future financial crises.

In October 2007 it was published that the total losses from subprime mortgage loans andrespective bonds is estimated at USD 250 billion. Ten American banks managed to create a

USD 70 billion liquidity fund, but no mention was made of investing three to four times moremoney in a larger fund in order to prevent possible avalanche effects. One year later, in thewake of the first blow of the crisis, when it was clear that the global economy was entering arecession, the first review of the global economic growth projections until 2015 was made.The difference between the new, lower and the previous growth path was USD 4,700 billion(nearly 19 times the total loss from subprime mortgage loans). Finally, at the end of

November 2008, after the situation in the global financial markets partly settled, a detailedrecord of the decrease in the consolidated values of all shares and bonds had been made. Thetotal recorded loss was USD 26,400 billion, which is over a hundred times the total value ofthe contentious mortgage loans. A one-time tax of 1% on the value of all shares and bonds inOctober 2007 would have been sufficient to entirely cover the financial gap which caused thecrisis on a global scale (Vujovic, 2009:36).

Figure 1: Spread dynamics of the crisis costs

Source: (Vujovic, 2009:38)

The global economic crisis of 2008 showed that the source of risk is not a poor businessdecision of an individual bank (inappropriate loan, bankruptcy of a company, etc.), but thecollapse of one type of financial instrument (sub-prime mortgage loan) in the circumstancesof over-indebtedness, poor regulation and high degree of interconnectedness at the nationaland global levels. Therefore, it is a systemic disruption which simultaneously affects a largenumber of banks in the country (U.S.) and in the world.

Today most banks provide liquidity by short-term borrowing on the financial markets. Banksfacing the problems with assets rapidly lose a rating, thus automatically losing access to thefavorable financing. Maturity of the existing short-term liabilities owed to the banks causes agap in the sources of funds which can be closed either by additional private financing sourcesor by capital increase. If it fails, the only solution is sale of assets or use of reserves in order tosettle maturing liabilities.

0 5000 10000 15000 20000 25000 30000

Bear Stearns warranty VI 2007

Total loss sub-prime credits X 2007

Lost GDP 2008-2015

Decline in the value of shares/bonds XI 2008

3

250

4700

26400

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In the circumstances of systemic risks, none of these methods gives good results. In adisrupted market there is no demand for risky assets, nor are additional capital sources oralternative long-term private financing sources available. Since many banks offer plenty ofassets for sale at the same time, the price falls further and jeopardizes even the minimal

provision of capital. It creates additional selling pressure for even more assets in order tomaintain at least minimum capital coverage and basic solvency. These two mechanisms aremutually enhanced and cause further deterioration of the conditions in the assets market.Capital coverage is very soon depleted and the liquidity problem becomes a solvency

problem.

To make things worse, financial markets respond to the crisis by excessive contraction and adrastic credit crunch. Financial institutions that were not affected by the initial crisis of sub-

prime mortgage assets could be affected by a rapid decrease in available loans. In thecircumstances of high degrees of securitization, it is very often necessary to refinanceconsiderable portions of short-term funding sources. If it happens that sources in the financialmarkets fail due to entirely exogenous factors, financial institutions may be involved in thewhirlpool of the crisis without immediate participation in the transactions that caused its firstcycle (Vujovic, 2009:41).

Based on the above mechanisms, the toxic assets spread very fast from the specialized banksand other financial organizations that were primarily dealing with sub-prime mortgage loansto all other players in the financial markets of the U.S. and other countries, as well as to thenew markets. Thanks to massive liquidity interventions taken by the Fed and other central

banks of the developed countries, in the following months the situation was partly improvedand prices stabilized; however, it was not sustainable in the long run. The asset price crashstarted with the outbreak of the global financial crisis in September 2008. At that time, toxicassets spread not only to all segments of the financial system of the developed countries, butalso reached through credit channels the new market, thus dominating all segments of theglobal financial system. A narrow definition of toxic assets confines it to mortgage backedsecurities and related derivatives and has been estimated at USD 2 trillion. It has been

proposed that the best solution for these assets should be reverse auction. This method can bean effective way to buy homogeneous assets, but it does not work well with mortgage-backed-securities because this market is much more fragmented than the market for corporate bonds(Pozen, 2010: 243).

All of the above reasons for the occurrence of the global economic crisis had another key

consequence. A decrease in real interest rates caused an increase in prices of property, i.e.assets. This means an increase in securities and real estate, which was made possible by theuse of mark-to-market value. Namely, this method, as a method of financial instrumentsvaluation, contributed to an increase in the asset value, because, as compared to the historicalvalue, the mark-to-market value of a financial instrument in the circumstances of economic

prosperity is considerably higher. It allowed further debt to be incurred, which consequentlyled to illiquidity, first of the banking sector and then of the overall economy. However, in

periods of turmoil, financial institutions are forced to write down the value of trading assets below their true economic value. Therefore, mark-to-market accounting, while well intended,could have unintended consequences of exacerbating economic downturns (Shaffer, 2010: 5).

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3. Mark to market accounting and the Great depression

Mark-to-market method, or fair value accounting, has been integrated in the U.S. financialreporting system for a long time. The first evidence of fair value implementation dates to

before the Great depression, long before the current crises. In 1921, the XXXI issue of the

Journal of Accountancy, the authors mention an implementation of fair values formeasurement of taxable income of buildings that had been sold and refer to established rulesand principles that had been established at the beginning of 1913 (Rusk, 1921). At that pointin time, the balance sheet had superiority over the income statement. However, at the end ofthe 1920s and at the beginning of the 1930s, the income statement had prevailed sinceshareholders demanded more information about their investment. Significant utilization of fairvalue had been recorded at this point which was also referred to as current value or appraisedvalue, for asset evaluation (SEC, 2008:34). However, there have been no accountingregulations or accounting standards issued that required the use of fair value, still manyentities used this method for evaluation of their assets. By 1920, the historical cost modeldeparted financial statements almost completely, and mark-to-market accounting took over.The Great depression had almost the same symptoms as the 2008 crisis: implementation offair value, huge writes-up and writes-down, and great mortgage debts.

Following the Great depression, the implementation of mark-to-market accounting faded, andafter 1938 it had been almost completely abandoned. In fact, it had been practically forbidden

by SEC release No 4 in 1938, where it stated that financial statements should be consideredmisleading or inaccurate if they lack significant authoritative support (Benston, 1973:133). Bythe end of 1940 the write-ups of assets almost completely disappeared from financialreporting since they had been unofficially banned. Conservative accounting methods had onceagain been embraced. However, the revival of mark-to-market accounting began in 1970 withdeclaration of authoritative accounting literature that proscribed the use of fair value in certaintransactions. This announced a significant and dominant use of mark-to-market valuations,having in mind that before this event accounting practices had been diverse. The same year,FASB issued SFAS 12 that enforced all marketable equity securities to be reported as thelower of cost, or fair value. Approximately from their point further, financial crises lastedlonger and had a stronger effect on the worldwide economy in comparison with previousones.

4. Legislation on mark to market accounting in U.S.

The primary users of financial statements are investors who seek the relevant informationabout entities profitability, liquidity and financial situation. All entities that trade on stockexchanges have the obligation to prepare financial statements according to specific rules and

principles which provide the universality and objectivity in financial reporting for all participants. The availability and preparation of financial statements; and the establishment ofaccounting standards are the main responsibilities of the SEC. The Financial StandardsAccounting Board (FASB) is the body accountable for developing accounting standards and

pronouncements. The chronology of standards related to fair value issuance is presented inTable 1.

Table 1. Order of issuance of mark-to-market accounting related legislature

Issued on Effective from Legislative Description 1. December Superseded with SFAS 12 Accounting for certain

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1975 SFAS 115 marketable securities

2. December1991 December 15 th,

1992 SFAS 107 Disclosures about fair value offinancial instruments (amended

by SFAS No. 126)

3. May 1993 December 15th,

19931 SFAS 115

Accounting for certaininvestments in debt and equity

securities

4. October 1994 Superseded byFAS 133| SFAS 119 Disclosure about derivative

financial instruments and fairvalue of financial instruments

5. June 1998 June 15 th, 1999 SFAS 133 Accounting for derivativeinstruments and hedging

activities

6. February 2000 / Statement of financialaccounting concepts 7 Using cash flow information

and present value in accounting 7. June 2001 July 2001 SFAS 141 Business combinations

8. 2007 December 15th,

2008SFAS 141 Revised Business combinations

9. June 2001 December 15th,

2001SFAS 142 Goodwill and other intangibleassets

10. August 2001 December 15th,

2001 SFAS 144 Accounting for impairment ordisposal of long-lived assets

11. February 2006 September 15th,

2006 SFAS 155 Accounting for certain hybrid

financial instruments

12. March 2006 September 15th,

2006 SFAS 156 Accounting for servicing of

financial assets

13. September2006 November 15 th,

2007 SFAS 157 Fair value measurements

14. February 2007 November 15th,

2007 SFAS 159 The fair value option forfinancial assets and financial

liabilities

15. March 2008 November 15th,

2008 SFAS 161Disclosures about derivative

instruments and hedgingactivities

16. October 2008 October 3rd,

2008

Report andrecommendations

pursuant to section 133of the Emergency

economic stabilizationact of 2008

Study on Mark-to-marketaccounting

Source: Addapted from: http://www.fasb.org/home

5. The relation between the issuance of mark to market accounting standards withthe overvaluation of real estate

In an attempt to prove that there exists a relationship between using mark-to-market methodsand asset price inflation, we will chronologically analyze the S&P 500 index as the bestreflection of the regulatory changes. We will however use the Shiller Barclays CAPE Indexwhich reflects cyclically adjusted price-to-earnings ratios (CAPE) since it has been a key

1For entities with total assets less than $150 million effective implementation of this standard began onDecember 15 th, 1995.

http://www.fasb.org/homehttp://www.fasb.org/homehttp://www.fasb.org/homehttp://www.fasb.org/home

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driver for the valuation of sectors. The numerator of the CAPE index is the real (inflation-adjusted) price level of the S&P 500 index, whereas the denominator is the moving average ofthe preceding 10 years of S&P 500 real reported earnings (Wilcox, 2011:1). The U.S.Consumer Price Index is used to adjust for inflation and the purpose of averaging 10 years ofreal reported earnings is to control for business cycle effects. The aforementioned index has

been defined by Robert Shiller and John Campbell in 1988 and is generally used by investorswith a buy and hold strategy and a multiyear time horizon. The Barclays ETN+ Shiller CAPEETN investment fund tracks the Shiler Barclays CAPE U.S. Core Sector Index. This fundinvests in the four most undervalued sectors among the nine S&P 500 sectors, based on theircyclically adjusted price to earnings ratios (Ho, 2012:1). Table 2 shows the movement of theaverage values of the CAPE index for a period of 31 years, ending in 2012. For the analysiswe have used Change-Point Analyzer, a shareware software package for analyzing timeordered data to determine whether a change has taken place and when the change occurred.This software detects multiple changes and provides both confidence levels (that changeoccurred) and confidence intervals for each change; the results of analysis are clearlydisplayed in table form.

Table 2. Significant changes for the CAPE index

Source : Authors data

The results show that the largest differences in average CAPE index values appeared in 1927,right before the onset of the great depression, when the use of mark-to-market methods wasalmost at today's high levels. Subsequently, the first significant differences in average CAPEvalues appear in 1995 and 1997, which reflects the implementation of the accountingstandards put in place in 1991, 1993 and 1994.These results are expected considering the factthat this method had been prohibited before the 1990s, so an acclimatization period wasexpected. After that we notice a significant change in average index values in 2002 as a resultof the first bubble, and in 2008 as a result of the second, and current world economic crisis.Graph 1 presents the changes in CAPE index averages from 1881 to 2012.

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Graph 1. Significant changes in CAPE average

Source : Authors data

In Graph 1 we notice larger oscillations in the movement of average CAPE values startingfrom 1913-1914, which is exactly the period where mark-to-market methods were extensivelyused in practice. A more stable period is seen up to 1974-1975, while these practices wereforbidden, but were subsequently reintroduced. We note similar erratic CAPE averagemovements in both waves of mark-to-market introductions which follow average CAPEdeclines. This confirms the assertions of authors like Pozen who favors this method in thesense that it offers greater transparency of property values than the historical cost approach.Protagonists of the mark-to-market approach often cite that the historical cost model does notreflect the current value of assets in the balance sheet and significantly understate them. In thecase of a growing economy, this method has a much stronger opposite effect of overstatingcapital values through financial statements.

Graph 1 also shows that greater oscillations in CAPE index value begin in 1913 and 1914,which collides with greater implementation of mark-to-market method. We also point out thatFED was formed in 1913, as well and that FED started printing, money so oscillations aredefinitely due to this situation. After 1971 when this method has been reintroduced, firstoscillations occur in 1974-1975. It should be noted that similar behavior occurs at the

beginning of mark-to-market implementation, the first and second time, namely CAPE valuedecreased. This confirms the findings of authors who claim that this method provides highertransparency in assets valuations, in comparison with historical cost method. However, in

conditions of overall prosperity this method has the opposite effect, since assetsoverestimations tend to quickly reflect in financial statements.

Quarterly financial reporting compounds the previously described effect which results inovervalued estimates of holdings and creates bubbles. Also, the combination of the nature offinancial instruments and interim reporting might be the reason why current crisis has such adevastating effects. Frequent financial statements tend to destabilize share prices. Quarterlyinterim financial reporting appears to induce greater capital market volatility than semi-annualreporting (Mensah and Werner, 2008:74). Valuation of financial instruments is more frequentand very demanding compared to the other assets, since sometimes it requires subjectivity inestimation. In overall prosperity and price booms, financial instruments get overestimated and

as such, appear more frequently in financial instruments of one company. Such values offinancial instruments when they are traded appear in financial reports of other companies and

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so on. Based on this, beginnings of crises can be expected in countries where mark-to-marketmethods have matured the most, leverage is highest, financial market is developed and wherefinancial reporting is done quarterly, which makes it understandable that the financial crisis of2008 hit the U.S. harder than Europe.

The Graph 1 also shows that during periods of growth, the effects of mark-to-marketaccounting are three times greater than during times of crisis. This indicates that theinstitution of this type of accounting does not create crises, but only serves to amplify theirnegative effects once they are already present compared to alternate methods. The followingdiscussion will outline the more and less obvious characteristics of mark-to-marketaccounting.

6. Mark to market accounting mechanism

6.1 Necessity of financial reporting

Financial statements present a traditional source of information in the decision making process. However, this dependency is not absolute since a company may have high netincome at the same time may not be liquid, however the effect of data presented is far fromirrelevant. Why do people believe so much in financial statements? Why do they requirefinancial statements so much? The main goal of f inancial statements stakeholders isestimation of financial stability and profitability. In the se estimates anchoring playsimportant role, since people seem to be influenced by the magnitude of cued numbers oractions. The initial value or the anchor presented in financial statements can serve as amental benchmark or starting point for estimating future earnings of financial instruments(Poundstone, 2010). These adjustments are usually inadequate and it seems that the anchorhas a magnetic attraction, luring the estimates closer to them. Anchoring is constrained bywhatever people believe or want to believe to be true (Poundstone, 2010).

Now, imagine if initial values are biased, on whatever level, and add to that the adjustment theinvestors will conduct; what would be the ultimate result? Would these estimates reflect thereal situation? There is another side of this effect as well, the investors would definitely denythe influence of anchor information on their estimations and most likely would ignore the realdata given , pointing out that they are skillful enough to make the estimates by themselves .As it has been beforehand stated, people tend to react to factors from surroundings. In the case

of investors, those factors should be the general trend of market earnings and the developmentof the economy. It is supposed that people are inclined to risk more prosperous economies in,which could be connected to the abovementioned statements that investors will estimatefuture earnings based on anchor information with higher optimism. On the other hand, indifficult conditions investors will certainly decrease the estimated earnings value even morethan the upward value in prosperity, which has already been shown.

Although it may sound unbelievable, accounting has been a stabilizing factor of worldeconomics for centuries. It seems that the Great depression and now World financial crisis

both had lesser effects on European countries than in the U.S. Many authors point out thesignificance of International Financial Reporting Standards (IFRS) and suggest that the U.S.

should implement IFRS instead of, or as a supplement to Generally Accepted AccountingPrinciples (GAAP). Over 100 countries use IFRS in financial reporting of listed companies,

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the newest additions being: Brazil, Canada, Korea, China and India (Ohlgart and Ernst, 2011:41). Accounting principles are usually considered as stabilizing factors in IFRS. GAAP are

based on common law and thus define rules that financial reporter should follow in specialsituations. On the other hand, IFRS are based on principles where financial reporter shoulddefine his actions based on general principle.

6.2 Association with accounting principles

While accounting regulators have been dealing with the harmonization of IFRS and GAAPfor some time, it seems that the implementation of accounting principles is more establishedin those countries where IFRS are statutory. There is a suspicions that the going concern

principle hasnt been implemented properly in countries that use GAAP, meaning thatcompanies arent regularly examining whether the company will continue its business in thefuture. However, we consider this as the final aspect of the mark-to-market accountingimplementation which goes against some of the fundamental accounting principles.

The principle of prudence requires that revenue should be recorded when it is certain orrealized, and a provision when an expense is conceivable. If a company has merchandise ininventory, it shouldnt report its value at market value because it would acknowledge the

profits that may, or may not, occur in the future. Those assets should be disclosed atacquisition cost or purchase value. When using mark-to-market accounting, determined valuecould include in itself unrealized gains, especially if there is an illiquid market for a certainasset. Also, the problem occurs when an asset is to be revaluated, changes in value mightnever be realized. The consequences are:

The balance sheet is overvalued and a total asset increase in value could be used fornew debts, or if there are huge write-offs total assets depletion could have negativeeffect on restrictive clauses and capital requirements

The income statement may include losses that will never be incurred and profits thatwill never be realized

The principle of reliability is usually interpreted as the quality of information that guaranteesexclusion of any error and faithfully represented what it intends to represent. In normalmarket conditions fair value as market value presents a faithful estimate. However, there aresituations demanding managements predictions and subjective estimates, where markets areilliquid and there is a lack of transaction on similar assets. This could result in miscalculationsand manipulation of estimated values. Mark-to-market accounting in those situations may not

produce reliable information. The principle of objectivity may not be fulfilled in previouslydescribed situations. This rule requires that information provided by financial reportingshould be unfettered from any subjective estimation, meaning that estimations made by oneaccountant should be similar or identical, if possible, to estimations made by some otheraccountant. Far value accounting goes against these principles.

It seems that accounting regulators attempted to soften the accounting principles andimplementation of the traditional, conservative, historical accounting method by introducingmark-to-market accounting. However, the main goal of this method was premature disclosureand recognition of future earnings that would not be disclosed if the historical method wasused. The intention was that speculative characteristics of mark-to-market accounting should

blend with conservative components of financial reporting resulting in a perfect

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combination of financial reporting. However, when conservative and speculative componentsare blended, characteristics of the speculative component prevail.

6.3 Association with impairments

As with the Great depression, the current financial crisis highlighted a significant number ofimpairments, especially in the area of intangible assets. Specific focus has been given togoodwill, because it can linger in balance sheets forever. Why did write-offs in intangibleassets (goodwill) occur in both crises? Unlike other tangible and intangible assets, goodwillisnt calculated for amortization. In circumstances when stock price falls note worthily below

book value, its time to do a balance sheet m akeover. This was a chance for many companiesto toss out overvalued assets from their balance sheets. And goodwill was that golden reservefor many companies.

At the end of 2008, the average amount of goodwill reported by 419 companies of theS&P500 was $1.2 billion, whereas median write-offs for the first half of 2008 were $211million (Mintz, 2009:72). The transaction of goodwill impairment is non-cash in its nature,which is fortunate because poorly governed companies usually dont have any cash to ba ck upthis transaction. Nevertheless, huge write-offs could have many consequences. Primarily, theycan influence the behavior of investors, since many CFOs are afraid that disclosure ofsignificant impairment can draw unwanted attention of investors and decrease the stock valuein the long run. On the other hand, there are authors that claim that investors can discerndifference between write-offs that will improve performance and write-offs that will not.Also, disclosure of impairment doesnt automatica lly mean tax benefit, because taxdeductions ordinarily occur when an asset becomes worthless and its value is zero. In all othercases, tax benefits will be omitted (Mintz, 2009:74). Investors are not the only stakeholdersthat companies should have on mind when deciding to conduct the impairment. Write-offsaffect the size of total assets and if they drop significantly to disrupt financial ratios thatlenders use as a main instrument to signal trouble in a company (debt-to-capitalization ratio),than management should think twice. Aforementioned circumstances of huge write-offsunderlines the importance of accounting methods used for asset valuations.

6.4 Association with GDP

The earnings of a country could be measured by the Gross Domestic Product (GDP). The

basic assumption is that economic development will affect market earnings and the value of products and services. The beneficial growth of an economy should lead to higher marketearnings which will be represented as higher GDP. This is what has been happening in U.S.during the eighties and nineties, up until 2006. Between 2001 and 2006, corporate profitsexplained around 98.4% of domestic GDP growth (Mays, 2011:1). However, the stock markethas been completely different story for the last several years, since it has become veryturbulent. In a bull market, earnings are overvalued, and in a bear market earnings areoverestimated. This is the main reason why S&P and nominal GDP do not correlate, althoughthey should. S&P 500 and GDP are not the same since S&P generates about less than a half ofthe earnings outside of the U.S. from overseas sales and operations. Also, a quarter of theGDP (government earnings) of the U.S. is not included in the S&P. However, the long term

correlation is obvious; GDP ha s a very strong correlation with a corporations earnings. This

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correlation has been even more obvious before we entered the period of volatility. Thefollowing chart presents the gap between S&P returns and nominal GDP growth.

Graph 2. The gap between S&P returns and nominal GDP growth

Source : Authors data

The observed period in Graph 2 is from January 1 st 1950 to August 1 st 2012. For analysis purposes, we use the Change Point Model (CPM) in the R software package. The Segment Neighborhood method is used with the assumption of a normal distribution of average CAPEindex values. We notice the point at which average CAPE index values changed in Graph 2.The change point date is identified as March 1st, 1995, which coincides with the introduction

of regular implementation of mark-to-market accounting practices. The average CAPE value before this date was 15.37024 and after this date is 27.32488. Even though it cannot beconcluded that GDP and the S&P 500 are not synonymous, an increase in GDP (under theassumption of stable net margins) is a good indicator of increasing capital values. In situationsof stable GDP growth (as seen in Graph 2), it can be seen as the aggregated value of themarket capitalization of the 500 largest companies. Graph 2 also shows that the movement ofthe S&P 500 index behaves similarly after the reduction of mark-to-market accounting

practices (1975). We again notice a fall in index values compared to GDP, which would againturn around after 1995 (after their reintroduction).

6.5 Association with pro-cyclical effect and leverage

Proponents of the mark-to-market accounting method often state that this methodologyimproves transparency and reveals inherent volatility, but does this transparency create a newtype of feedback loop volatility as a byproduct. If this is true, we can argue that additionaltransparency comes at an unjustifiable economic price.

When it comes to implications for investors, it is well known that investors and financialinstitutions accept higher risk in order to achieve increased returns when an economy is in thehigh phase of the cycle. However, this also leads to higher credit borrowing and leveragedexpansions. Also, a well-known phenomenon is the effect of the balance sheet.Implementation of mark-to-market value leads to asset, namely financial instrument,overestimation during market growth. This results in stronger balance sheets, higher amounts

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of assets and capital presented in balance sheets, which raises the willingness of lenders todecrease the credit rate and extend credit. This ultimately leads to additional capital

borrowing. Increased leverage causes higher earnings and equity presented as OCI, whichleads to stock price appreciation. It seems that risk evaluation by investors and financialinstitutions is based on recent history of market trends, so in periods of prosperity their

actions seem to be over exaggerated.

Based on the investigation of the SEC of all assets that were reported at fair value, a majority(76%) of the assets were Level 2 instruments for which inputs were observable, followed byLevel 1 instruments (15%) which had quoted prices, and Level 3 instruments (9%) wheresignificant market information is not observable (SEC, 2008:60). In situations wheremanagement subjectively ascertains values of capital possessions, it is logical to assume thatthese values tend to be inflated. However, in a financial system in which balance sheets arecontinuously marked to market, asset price changes appear immediately as changes in networth, prompting financial intermediaries to adjust the size of their balance sheets (Tobiasand Song, 2010:418). On the other hand, as a reaction to increased company capital, leverageis increased (especially in investment banks). In this situation, leverage and total assets tend tomove in lock-step (Tobias and Song, 2008:3). This happened not only in 2008, but also in1998. The early part of 1998 saw strong growth in total assets, with the attendant increase inleverage. However, the third and fourth quarters of 1998 shows all the hallmarks of financialdistress and the attendant retrenchment in the balance sheet. For most banks, there were verylarge contractions in balance sheet size in the fourth quarter of 1998, accompanied by largefalls in leverage (Tobias and Song, 2010:15).

We therefore underline that the consequences of mark-to-market accounting are greatertransparency in the declaration of capital values, but also greater volatility in business cycles.Exaggerated profits in good times create the wrong incentives. Conversely, more uncertaintysurrounding valuation in downturns may translate into overly tight credit conditions, andnegatively affect growth at a time when credit expansion is most needed (IMF, 2008:123). Tosum up, asset appreciation momentum leads to institutional shareholders gain; this again leadsto a positive feedback loop. Nevertheless, when negative event occurs, like the LehmanBrothers crash, such investors risk evaluation violently fluctuates. Previously stated areeconomic and psychological factors that lead to pro- cyclical investors behavior d uring therecession. Furthermore, Chea noticed some interesting manifestations of this methodsimplementation: fair value reflects the effects of changes in market conditions and changesin fair value reflect the effect of changes in market conditions wh en they take place (Chea,2011:15). It should be mentioned, as well, that rating downgrades of one firm could create

pressure for the downgrades of other firms, in a form of feedback effect not studied in thecurrent paper (Manso, 2011:4).

The fear from pro-cyclical behavior can be seen in Europe as well, where they alreadyexamine the countercyclical regimes that would help banks to save capital in beneficial years.Many authors believe that capital adequacy rules did not have a significant effect on thedebris of big financial institutions; however Europes national regulators suggest discretionwhen using these rules in times of distress.

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6.6 Association with systematic risk

At first glance, valuating assets in financial statements does not have many points of contactwith systemic risks; however, valuating property does. As opposed to the risk that onecompany will stop functioning, systemic risk entails the entire sector stops functioning (ex.

the banking sector). The implementation of this method has a doubly negative effect onsystemic risk.

Overvaluing property in one company and changing the standards that allow this type ofreporting only shortsightedly reduces its bankruptcy risk. However, in the long run, systemicrisk is greatly increased. Stronger financial statements influence credit rating agencies to givemore positive scores, which influences financial institutions to offer more credit to suchcompanies. The former is not economically justified because such companies do not deservethis extension of credit that is created due to mark-to-market accounting. Such occurrencesnot only impact the financial instruments market, but have an effect on the overall economy.

An increase in the value of financial instruments overflows into the property market whichcauses property bubbles. This breeds an additional impression of overall prosperity on thestock market which is then spread to the whole economy including the real estate market andlanding activities. The real estate valuers played their role as well, since they use methods forvaluation which are comprised of general rate of return. The constant increase of these ratesgradually and unduly increases the value of real estates. The increase which was contained infinancial instruments is now set free on the market. The housing market was susceptible to a

bubble because of the long period of decreasing interest rates and lack of diligence andalertness exhibited by mortgage institutions. All of this impacts the level of systemic risk.

There is another form of negative impact of mark-to-market accounting on systemic risk. Fora system to function properly there must be a balance between supply and demand.Companies, especially banks, come into the possession of assets that are drasticallyovervalued. There are 2 solutions to this problem: selling assets at fire-sale prices, or keepingthese assets on the books and reporting amortization losses. The choice of the best solutiondepends on the style of management of the company, but in both cases will result in increasedsystemic risk through oversupply or over-demand. Systemic risk is increased, and firmspecific risk is decreased in the short term, due to the dumping of toxic assets.

7. Conclusions

We reaffirm that mark-to-market accounting did not cause the financial crises, but it enabledit to happen and amplified its consequences. While the mark-to market-rule does not causefinancial crises on its own, it does magnify the underlying market volatility caused by the

positive feedback mechanism inherent in efficient market economies. Mark-to-marketaccounting does not only reveal volatility, it is also generates it. It does deliver more of themarket risk in every single portfolio. It tends to stabilize market returns in periods of positivefeedback, but doubly or triply destabilizes them in periods of negative feedback. It breeds anadditional impression of overall prosperity on the stock market which is then spread to thewhole economy including the real estate market and landing activities. It also affects the levelof systemic risk. It is clear that regulatory bodies notice the negative consequences of the

implementation of this method and the fact that it played a significant role in financial crisesthrough the history of its use, which makes it understandable that they wish to educate

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