'Mark to Market' Accounting and the Credit Crunch

On September 5, the market for farm land is rocked by rumors that between five and 10 percent of the farm land in the country has been contaminated with viral spores that make those acres unsuitable for agricultural use and, therefore, virtually worthless for production. No one has any idea which acres are contaminated, if the land will recover before next planting season, or how long it will take to identify which acres are contaminated. 

 
Suddenly, as market participants digest this information, they view farm land as a highly risky investment, when it had been perceived as nearly the safest investment on earth, and adjust their demand for that investment accordingly. With farm land investments being a great deal riskier now than they had been perceived only a week before, rational investors are willing to pay a great deal less for that land, discounting all such purchases by 30-40 percent to balance out the increased risk and uncertainty of returns. Part of that overall de-valuation is due to the five to 10 percent of farm land that is contaminated and will not likely be of any value in the foreseeable future (i.e., macro-level losses) but the remaining 25-35 percent discount is just to allow for the uncertainties of each individual investment in farm land (micro-level losses).

As far as the bank and the farmer are concerned, nothing has changed: the farmer is still paying as-agreed and any losses on the loan remain purely theoretical.

Mark to Market Panic

Unfortunately, Mark T. Market is the bank's auditor and he does not see the glass as merely half-full; he sees the half-full glass as positive evidence of a leak in the glass. 

A little background: There has been a lot of discussion lately regarding the mark to market requirements of the Sarbanes-Oxley Act of 2002 (Sarbanes-Oxley). Officially known as the "Public Company Accounting Reform and Investor Protection Act of 2002," this law was enacted in response to a series of high profile corporate financial scandals, the most-famous of which were Enron, Tyco, Adelphia, and WorldCom.  The crux of the mark to market element of Sarbanes-Oxley was to require all publicly traded companies to report their assets at their current market value instead of a number of other options which had been used by some corporations to "fluff up" their earnings and balance sheet equity (e.g., net present value of cash flow), when there is an active market for those assets.