Sometimes it's hard to see the answer clearly when the proposed solution is more complicated than it needs to be. That's the problem with the mark-to-market accounting concept. In an economy that continues to decline, this rule has forced the devaluation of a performing asset class that was never intended to be treated like a security.

It's not about hiding a true value; it's about not being able to determine a fair value. Investors who need long-term assets shouldn't be forced to devalue those assets based on fire-sale prices.

The demise of Wall Street has proven one long-held belief: Investment bankers are — or were — first and foremost good salespeople. After years of consideration and largely failed attempts, they saw an opportunity in the early 1990s to step into a market that they had been excluded from — the sale and delivery of investments in real estate loans. Mortgages became a part of the larger evolution of asset-backed securities.

Specifically, they came to the marketplace with a profitable new idea that converted the commercial mortgage asset class from a hold-to-term investment with value based on performance to a trading investment with value based on the market. Their idea was to sell a product with promised liquidity and a high percentage of investment-grade ratings, allowing investors an easy investment opportunity into this asset class.

These two fundamental characteristics converted a class of investments from whole loans to securities. The beauty of this concept from the investor's perspective was that someone else would do the underwriting and due diligence, and rating agencies would stamp their approval. All investors had to do was buy.

Whole loans fell out of favor and demanded higher spreads. But fundamentally, we were dealing with the same asset that historically filled an investment need for long-term, fixed returns. There was no intention to change the nature of the investment or how it was accounted for, or to hide the true value. There was an intention to sell a product and to make a profit in the process.

Pitfalls of mark-to-market

One unintended consequence was that instead of holding a portfolio of well-underwritten, performing mortgages that met the investor's own guidelines and were treated under hold-to-term valuation rules, those investors received a commercial mortgage-backed security (CMBS) that required fair value or mark-to-market accounting treatment. This idea worked fine, as long as a market for the paper existed; it does not work at all when the market is illiquid.

Mark-to-market accounting attempts to develop a formula that answers a hypothetical question: “What is the real value of an asset when no one is buying?” In the process of defining this accounting rule, we have created confusion and fear.

And fear is now preventing the risk-taking implicit in trading, thereby adversely affecting the value we are trying to determine. Ironically, as the accountants and regulators struggle to solve the value question, they force devaluation. In turn, this concept is causing a lending freeze and the consequent devaluation of the underlying asset — in this case, commercial real estate.

We need to treat these long-term, fixed-income investments as such. Unlike the majority of CMBS, when you hold a portfolio of whole loans, you reserve for actual or reasonably expected losses based on the characteristics and performance of those assets. If the mortgages are all paying as agreed and the rent roll is stable, you have a fairly low reserve requirement. That reserve offsets your value and accurately reflects the effective performance.

Unfortunately, with mark-to-market, all that matters is the price someone else is willing to pay for your paper. Or more to the point today, the value is determined by a third party without the benefit of actual market trades. It's no longer what the market thinks, it's what your auditor thinks. Some argue that hold-to-term accounting is akin to ignoring fair value.