The financial industry has been wrestling for some time over the issue of market-value accounting. Emotions flare at the mere mention of the subject, and there may be no quick end to the warfare.

Lenders have argued that their shops and assets are not for sale, but are held over time to produce a return. But doesn't sound management require lenders to consider how market forces affect asset quality, and to use this information to maximize performance?

Consider the mark-to-market issue from a slightly different perspective: not whether it should or should not be required, but whether the discipline, in and of itself, can benefit institutions holding all types of assets, particularly commercial real estate mortgages.

Opponents' Rationale

Those who have successfully argued against marking to market say it is unreasonable to require such disclosure because many assets, such as commercial real estate mortgages, are long-term investments subject to market volatility.

The argument follows that forcing an institution to mark loan assets to market during a down cycle causes undue public and investor concern. Such news further depresses the institution's stock and capital position, and in the long run may cripple its ability to recover from short-term losses or to expand.

On the other side, the investment community, federal regulators, and public interest groups say market-value accounting enables them to better analyze the institution's long-term earnings potential and financial strength - or lack thereof.

Asset value and institutional value are, of course, closely related. The loan portfolio's ability to generate cash flows according to expectation has a significant effect upon the institution's earnings and therefore serves as a determining factor in calculating equity.

For example, consider the financial productivity of two similar companies, each with $1 million of net worth. For simplicity's sake, assume each company has one asset, a $1 million security.

Difference in Returns

Both assets were purchased at par, but since they were acquired at different times, Company A is earning 8% on its security, while Company B is earning 10%.

Under historical accounting practices, both companies would have the same book value. However, from a market-value perspective, Company B has 25% greater earnings potential than Company A.

In addition, Company A continues to experience the lost opportunity associated with holding a lower-earning asset.

From a shareholder perspective, Company B has more earning power, and therefore its stock should be valued accordingly even though it has the same book value as Company A.

Since the 10% security would have a higher market value than the 8% security, mark-to-market accounting would better reflect the investment values of the two companies.

Dramatizing the Issue

Multiply this scenario by all of the many assets typically held by a bank, thrift, or insurance company and you will see the rationale behind marking to market.

With commercial real estate mortgages, value is supported by the property's ongoing ability to generate cash flows consistent with its pro forma.

These future cash flows are subject to a multitude of risk factors not necessarily under the control of either the lender or the borrower, a condition that makes valuation difficult.

Assessing market value requires sophisticated financial models and technically proficient professionals: it means collecting and maintaining comprehensive loan and collateral information, tracking market trends, keeping operating statements and site inspections current, and most of all, combining all this with a little gut instinct and market savvy.

Here is where the mark-to-market argument usually stalemates. The process for commercial real estate is viewed as unreasonably time-consuming and resource-intensive.

A History of Retention

Thus, carrying the assets at book value is deemed appropriate and acceptable, particularly since commercial real estate mortgages are normally held to maturity. Even if an institution were inclined to sell favorable secondary-market conditions don't always exist. The discount or credit enhancement may simply be too expensive.

In their resistance to regulatory pressures and increasing costs, could it be that institutional managers are overlooking the many ancillary benefits that tracking market value offers as an internal portfolio-management discipline?

The data base required to model the market value of commercial real estate mortgages, for example, can be applied to a number of vitally important and interrelated management and operational objectives.

The Univest market-value model, for example, accounts for the many factors that affect future earnings potential and the collateral's ability to cover debt service and operating expenses. Consistent with mark-to-market theory, the model values each loan as if it were an ongoing business enterprise.

The model includes considerations for the loan's terms, legal and environmental deficiencies that affect the lender's ability to foreclose, and the value of the collateral as supported by current leases and operating statements, regular site inspections, and market surveys.

Managing Resources

By maintaining current information and relying on market values to measure earnings potential, institutions can increase asset quality and better direct their financial resources.

Factors that positively influence market value, such as product design, property type, borrower type, legal terms, and site location can be identified and used to structure future deals.

The regulatory and rating agencies tend to look more favorably upon institutions who are able to produce comprehensive loan-asset management information at a moment's notice.

This capability could translate into lower loan-loss reserve requirements, or an improvement in the institution's investment rating.

Some say disclosing mark-to-market values may actually improve equity values by reducing the discount currently taken for the "uncertainty factor."

Responsiveness Improves

Often, time horizons are short, windows close quickly, and opportunities - both for asset dispositions such as securitizations and for new investments - are missed because analysis, valuation, and due diligence cannot be performed in time to respond while conditions are ripe.

The information-management discipline required to model market value has many ancillary benefits that could, for most institutions, far outweigh the initial cost of collecting and maintaining the data.

In addition to enhancing the loan-portfolio management and marketing process, it prepares the institution for the near certainty that some form of mark-to-market accounting will eventually become a standard for all financial institutions. FAS 107 may be the first signpost.

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