Buffett "Endorses" Mark-to-Market Because of It’s "Strange Results"

ToddSullivan
February 28th, 2009

Now, before mark-to-market fans get all excited, one needs to take a close look at what Berkshires (BRK.A) Chairman says about it.

For those not sure where I stand on it, visit a past post.

From the Annual Letter.

Buffett makes the following statement, “We endorse mark-to-market accounting”.

Now, is it for the transparency its advocates seem to think it produces? On that subject Buffett says “Improved “transparency” – a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks – won’t cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives.

Auditors can’t audit these contracts, and regulators can’t regulate them. When I read the pages of “disclosure” in 10-Ks of companies that are entangled with these instruments, all I end up knowing is that I don’t know what is going on in their portfolios (and then I reach for some aspirin).”

If he does not believe that true transparency is possible simply due to the complexity of the instruments, then why would he support mark-to-market? What does the particular accounting system solve or produce that he finds of value?

Later he says:

“At the request of our customers, we write a few tax-exempt bond insurance contracts that are
similar to those written at BHAC, but that are structured as derivatives. The only meaningful
difference between the two contracts is that mark-to-market accounting is required for derivatives whereas standard accrual accounting is required at BHAC.

But this difference can produce some strange results. The bonds covered – in effect, insured – by these derivatives are largely general obligations of states, and we feel good about them. At year end, however, mark-to-market accounting required us to record a loss of $631 million on these derivatives contracts. Had we instead insured the same bonds at the same price in BHAC, and used the accrual accounting required at insurance companies, we would have recorded a small profit for the year. The two methods by which we insure the bonds will eventually produce the same accounting result. In the short term, however, the variance in reported profits can be substantial.

We have told you before that our derivative contracts, subject as they are to mark-to-market
accounting, will produce wild swings in the earnings we report. The ups and downs neither cheer nor bother Charlie and me. Indeed, the “downs” can be helpful in that they give us an opportunity to expand a position on favorable terms. I hope this explanation of our dealings will lead you to think similarly.” (Emphasis mine)

Buffett believes that mark-to-market accounting produces the very inefficient market pricing that he searches for and seeks to exploit. He gives a wonderful example how the same security, held in a different part of Berkshire and thus accounted for differently produces a far different results (one a large loss, the other a small profit).

Buffett’s endorsement of mark-to-market is NOT an endorsement of it as the best accounting system but an endorsement of it as an accounting system prone to producing conditions in which he believes he can profit handsomely.

Let’s see how the MSM and politicians run with this one……

Disclosure (“none” means no position):None.

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