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Mark-to-Model What it Means How it Works

Mark-to-Model What it Means How it Works

Mark-to-Model: What it Means, How it Works

What Is Mark-to-Model?

Mark-to-model is a pricing method for a specific investment position or portfolio based on financial models. This contrasts with traditional mark-to-market valuations, in which market prices are used to calculate values as well as the losses or gains on positions.

Assets that must be marked-to-model either don’t have a regular market that provides accurate pricing, or have valuations that rely on a complex set of reference variables and timeframes. This creates a situation in which guesswork and assumptions must be used to assign value to an asset, making it riskier.

Key Takeaways

  • Mark-to-model involves assigning values to assets using financial models rather than normal market prices.
  • This valuation is necessary for illiquid assets lacking a large enough market for mark-to-market pricing.
  • Mark-to-model assets tend to be riskier as their values are based on guesswork.
  • The securitized mortgages that caused the 2008 financial crisis were valued using mark-to-model valuations.
  • After the crisis, all companies holding mark-to-model assets are required to disclose them.

Understanding Mark-to-Model

Mark-to-model valuations are primarily used in illiquid markets for products that don’t trade often. Mark-to-model assets are open to interpretation and can create risk for investors. Legendary investor Warren Buffett referred to this valuation method as "marking to myth" due to the underpricing of risk.

The dangers of mark-to-model assets became apparent during the subprime mortgage meltdown in 2007, as mispricing of risk and assets occurred. Billions of dollars in securitized mortgage assets had to be written off on company balance sheets due to inaccurate valuation assumptions. Many mark-to-model valuations assumed liquid and orderly secondary markets and historical default levels. These assumptions proved wrong when secondary liquidity disappeared and mortgage default rates spiked above normal levels.

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As a result of the balance sheet issues caused by securitized mortgage products, the Financial Accounting Standards Board (FASB) issued a statement in November 2007 requiring all publicly traded companies to disclose any assets on their balance sheets that rely on mark-to-model valuations starting in the 2008 fiscal year.

Level One, Level Two, and Level Three

FASB Statement 157 introduced a classification system to bring clarity to corporations’ financial asset holdings. Assets (and liabilities) are divided into three categories:

  • Level 1
  • Level 2
  • Level 3

Level 1 assets are valued according to observable market prices. These assets include Treasury securities, marketable securities, foreign currencies, commodities, and other liquid assets for which current market prices can be readily obtained.

Level 2 assets are valued based on quoted prices in inactive markets and/or indirectly rely on observable inputs such as interest rates, default rates, and yield curves. Corporate bonds, bank loans, and over-the-counter (OTC) derivatives fall into this category.

Finally, Level 3 assets are valued with internal models. Prices are not directly observable, and assumptions, which can vary widely, must be made in mark-to-model asset valuation. Examples of mark-to-model assets are distressed debt, complex derivatives, and private equity shares.

Finally, Level 3 assets are valued with internal models. Prices are not directly observable, and assumptions, which can vary widely, must be made in mark-to-model asset valuation. Examples of mark-to-model assets are distressed debt, complex derivatives, and private equity shares.

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