A biopharmaceutical firm thought it had a healthy balance sheet - until September 2008. Then it suddenly found itself in a perfect storm. The plunge in global markets pushed its market capitalization and share price below the threshold needed to maintain its listing on the Nasdaq Global Market. It was under threat of being delisted.
But there was an even more immediate concern: The company's balance sheet included a $24 million position in auction-rate securities. The position had been established by the company's broker, Lehman Brothers, without management's knowledge. It seemed safe enough. The securities were based on bonds - largely corporate and municipal bonds with a 30-year time horizon, as well as government securities, primarily in the student loan market. The securities were a money-market-like investment, with the only apparent difference being that funds were available not daily, but once a week when the securities went to auction and the rates reset.
Then - almost literally overnight - the position came apart. The market in auction-rate securities collapsed and the auction process came to a halt. It was the weekly auction that was the source of cash - without it, the holdings were 30-year bonds that couldn't be redeemed. And due to mark-to-market rules, the value of the securities disappeared from the company's balance sheet. While the bonds had inherent value, the securities couldn't be traded and had severely diminished value. The situation was critical.
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An intensive negotiation process with Lehman Brothers led to a Friday-night agreement - Lehman would cover the position and put $24 million back in the company's account. The following Sunday, Lehman went bankrupt, taking the agreement with it. In desperate straits, the company arranged to sell the securities to an Icelandic bank that was also one of its investors. The purchase price? $11 million, or 40 cents on the dollar. Still pressed for cash, the company took the only action it could - it sold its key patent, the foundation for its business plan and the basis for its long-term prospects. The company was able to cover its cash needs - at the cost of its future.
THE REAL WORLD
This is a true story and one that points up a dangerous fact: Mark-to-market accounting isn't just an abstraction or a matter for policy debate - or a concern only for banks. It's a real accounting practice that can lead to real consequences for businesses right here, right now.
Mark-to-market accounting, a component of the fair value accounting hierarchy, has been associated in the public's mind mainly with the financial crisis. The process - which is, of course, common - requires that certain balance sheet assets be priced at their current market value, even if they don't have to be sold and even if the market isn't liquid. The practice had a significant impact on the banks that hold so-called "toxic assets" - affecting their capital, liquidity and credit-worthiness.
There are many arguments for and against the application of mark-to-market in the banking industry and suggestions for changes in how the rules are applied. The Financial Accounting Standards Board's recent guidance to ease mark-to-market rules and give companies more leeway in reporting the value of their assets is the farthest-reaching example to date of mark-to-market reform.
