2009-02-11 | Filed Under SteveG's Posts |
In order to evaluate a person’s or a company’s net worth, you must be able to put a value on the holdings of that person or company. One definition of value is what a willing buyer and a willing seller agree as to the price of an item to be traded.
When you have to put a value on something that you have no intention of selling at the moment, one could look at what the market is saying about similar assets that are being traded at the moment. You could estimate that your similar asset has this value. If you mark your asset to market, then you are not putting in your own possibly distorted and self-interested view of the value of the asset. Mark-to-market sounds like a fairer and more honest way to value your assets.
However, even in the best of times, mark-to-market can distort the value of an asset.
Look at the way we put a value on the stock of a publicly traded company. We value every share of that company at the price that a small percentage of that company’s share are trading for at any given moment. It is quite obvious that the vast majority of the owners of the shares are not interested in selling at the current price because they are in fact not selling at the current price.
Even if they all wanted to sell at the current price, suddenly there would not be enough buyers at that current price.
So we can see that mark-to-market is only a measure, and sometimes a very faulty measure, of the value of an asset. The very idea of an asset having an accurately measurable value is probably just an abstraction. Although it is an essential abstraction in the workings of any large economic system.
When a measure of value that makes an economic system work well, suddenly becomes toxic, it may be time to think of a better way. The way we see mark-to-market become toxic is that certain loan and other contractual arrangements that a person or company may make depend on an assessment of the value of the asset. When the value of that asset drops below a contractually set percentage of a loan, the borrower may be forced to raise more equity. This may force the borrower to sell the asset. This is hardly the definition of a willing seller.
The act of many borrowers suddenly being forced to sell, only makes the value to the market lower. This in turn forces more sales until the prices spiral down to a level where there are enough buyers for all of these assets suddenly going on the market. This is certainly not good for the economy in the short term.
There are other ways to value an asset. One could use the replacement cost of an asset to value it. If the asset produces income, one could use a discounted cash flow model.
Can we set up accounting rules that allow for other measures of an asset value that would not force people and companies to take economically ruinous actions? Is it a good idea to do so? Or are these seemingly ruinous actions actually good for the economy in the long term? What about the affect on individual people even if the total effect might be good in the long term?