Mark to market rules and efficiency of financial markets

Paul De GrauweUniversity of Leuven

and CEPS

Mark to market rules are based on the view that market prices provide the best available information about the correct value of underlying assets

This is the same as saying that mark to market rules assume markets are efficient i.e. market prices reflect all relevant

information Usefulness of mark to market rules

depends on market efficiency

Are financial markets efficient?

Let’s look at the stock markets first; Take US stock market (DJI, S&P500) (same story can be told in other

stock markets) And exchange markets

Dow Jones and S&P500

US stock market 2006-08

What happened between July 2006 and July 2007 to warrant an increase of 30%?

Put differently: In July 2006 US stock market capitalization was

$11.5 trillion One year later it was $15 trillion

What happened to US economy so that $3.5 trillion was added to the value of US corporations in just one year?

While GDP increased by only 5% ($650 billion)

The answer is: almost nothing Fundamentals like productivity growth

increased at their normal rate The only reasonable answer is:

excessive optimism Investors were caught by a wave of

collective madness that made them believe that the US

was on a new and permanent growth path for the indefinite future

Then came the downturn with the credit crisis

In one year time stock prices drop 30% destroying $35 trillion of value

What happened? Investors finally realized that there had

been excessive optimism The wave turned into one of excessive

pessimism We still do not know where this will end.

Nasdaq :similar story

0%

100%

200%

Similar story in foreign exchange market

DEM-USD 1980-87

1.3

1.8

2.3

2.8

3.3

1980

1981

1982

1983

1984

1985

1986

1987

Euro-dollar rate 1995-2004

0,6

0,7

0,8

0,9

1

1,1

1,2

1,3

6/03/95 6/03/96 6/03/97 6/03/98 6/03/99 6/03/00 6/03/01 6/03/02 6/03/03 6/03/04

Since 1980 dollar has been involved in bubble and crash scenarios more than half of the time

While very little happened with underlying fundamentals

Market was driven by periods of excessive optimism and then pessimism about the dollar

Mark to market in a world of market inefficiency

We are told that mark to market is the right way to value assets

Thus from July 2006 to July 2007 this rule told accountants that the massive asset price increases corresponded to real profits that should be recorded in the books.

These profits, however, did not correspond to something that had happened in the real economy

They were the result of “animal spirits”

As a result mark to market rules exacerbated the sense of euphoria

and intensified the bubble Now the reverse is happening Mark to market rules force massive

write downs correcting for the massive overvaluations introduced just a year earlier

intensifying the sense of gloom and the economic downturn

A note

Bankers now complain about mark to market rules

now that the market goes down They did not complain during the

upturn As a result, their credibility is weak

Conclusion Mark to market rules show excessive

confidence in the efficiency of financial markets

There is now substantial evidence that financial markets are not efficient Inefficiency does not lead to just a few

percentage points of over- or undervaluation of assets

but of massive and systematic misalignment of market prices

Yet many people continue to believe in the market’s infallibility

and impose rules based on an idea that comes closer to religion than to science

As a result, these rules exacerbate financial and macroeconomic instability

New rules should be designed They should not eliminate market

prices altogether But they should bring some inertia

in these prices Throw some sand in the wheels of

financial markets.