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Mark to market rules and
efficiency of financial markets
Paul De Grauwe
University of Leuven
and CEPS
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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
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i.e. market prices reflect all relevant
information
Usefulness of mark to market rules
depends on market efficiency
Are financial markets efficient?
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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
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What happened between July 2006 and
July 2007 to warrant an increase of 30%?
Put differently:
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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)
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The answer is: almost nothing
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Fundamentals like productivity growth
increased at their normal rate
The only reasonable answer is:
excessive optimism
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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
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Then came the downturn with the credit
crisis
In one year time stock prices drop 30%
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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
200%
100%
0%
DEM-USD 1980-87
3.3
Similar story in foreign
exchange market
2.8
2.3
1.8
Euro-dollar rate 1995-2004
1,3
1.3
1987
1986
1985
1984
1983
1982
1981
1980
1,2
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
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0,9
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0,7
0,6
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
Mark to market in a world
of market inefficiency
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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”
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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
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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
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Mark to market rules show excessive
confidence in the efficiency of financial
markets
There is now substantial evidence that
financial markets are not efficient
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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
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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
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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.