Scholes And Merton Call For Broadening Mark-To-Market

Every once in a while, economists worth listening to agree about something important. This week such an occurrence took place through the Financial Times and Bloomberg Radio. Robert Merton and Myron Scholes are two such economists. They, along with Fischer Black, developed the Black-Sholes option pricing model some years ago. Merton and Scholes were awarded the Nobel Prize for economics in 1997 for the method. They both have come out in support of banks providing more transparent, market-based values for all if their assets, also known as marking-to-market.

The Financial Times yesterday contained an op-ed was written by Merton along with professors Robert Kaplan and Scott Richard of Harvard Business School and Penn's Wharton School, respectively. They argue that allowing banks to use their own assumptions to determine the value of complex assets is unacceptable. Their piece states:

This is not the way forward. While regulators and legislators are keen to find simple solutions to complex problems, allowing financial institutions to ignore market transactions is a bad idea.

They explain the strange paradox that can occur through an example where a bank originated a mortgage that it values based on what it believes the mortgage would be worth if held to maturity, instead of its market value:

The bank is likely to ignore this offered price, or trades of similar assets, with the claim that unusual market conditions, not a decline in the value of the assets, causes a lack of buyers at the origination price. Its real motive, however, is to avoid recognising a loss. Yet, by keeping assets at their origination value, the bank creates the curious possibility that its traders could buy an identical loan more cheaply and so carry two identical securities in the same not-for-sale account at vastly different prices.

That's kind of like in algebra if you said x=2 and x=3. It's nonsense. They also believe that the market will function more effectively if assets are marked-to-market:

Financial assets, even complex pools of assets, trade continuously in markets. Markets function best when companies disclose valid information about the values of their assets and future cash flows. If companies choose not to disclose their best estimates of the fair values of their assets, market participants will make their own judgments about future cash flows and subtract a risk premium for non-disclosure. Good accounting should reduce such dead-weight losses.

I agree wholeheartedly. Accounting should always have the goals of transparency and reducing market risk, not enhancing it. I won't copy and paste their entire piece here, but strongly suggest you give it a read, as they provide great detail on why and how this should be done by banks.

Today, Bloomberg further reports that Merton's partner in winning the Nobel Prize, Myron Scholes agrees. He said so during a Bloomberg radio interview. Additionally, he said:

"I'd like to see us encourage many more securities held on the books of the banks be migrated to exchanges if possible," he said. Doing so would "allow for market discovery and market pricing as much as possible," Scholes added.

I think that's a sensible goal. As he notes, not all securities, especially certain types of derivatives, can be realistically placed in an exchange, but many could be. The easier it is for the market to know the value of an asset, the more liquidity and the better it will function.

Who might be listening to the voices of these wise economists? Possibly the accounting community. As I noted several weeks ago, that's particularly relevant since the Financial Account Standards Board is considering changes to fair value accounting. Those proposed changes would please Merton and Scholes. It may require banks to mark all assets to their market values. That might not make banks happy, but it should please investors, economists and pretty much everyone else who wants a healthier, better functioning economy in the long-run.