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, which makes the asset riskier.
- Mark-to-model involves assigning values to assets using financial models as opposed to normal market prices.
- The need for this valuation arises due to illiquid assets that don't have a large enough market for mark-to-market pricing.
- The assets tend to be riskier as their values are based on guesswork.
- The securitized mortgages that brought on the financial crisis of 2008 were valued using mark-to-model valuations.
- After the financial crisis, all companies holding assets valued via mark-to-model are required to disclose them.
Mark-to-model valuations are used primarily in illiquid markets on products that don't trade often. Mark-to-model assets essentially leave themselves open to interpretation, and this can create risk for investors. Legendary investor, Warren Buffett, termed this method of valuation as "marking to myth," due to the underpricing of risk.
The dangers of mark-to-model assets occurred during the subprime mortgage meltdown beginning in 2007 due to this mispricing of risk and therefore of the assets. Billions of dollars in securitized mortgage assets had to be written off on company balance sheets because the valuation assumptions turned out to be inaccurate. Many of the mark-to-model valuations assumed liquid and orderly secondary markets and historical default levels. These assumptions proved wrong when secondary liquidity dried up and mortgage default rates spiked well above normal levels.
Largely as a result of the balance sheet problems faced with 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 beginning in the 2008 fiscal year.
Level One, Level Two, and Level Three
FASB Statement 157 introduced a classification system that aims to bring clarity to the financial asset holdings of corporations. Assets (as well as liabilities) are divided into three categories:
- Level 1
- Level 2
- Level 3
Level 1 assets are valued according to observable market prices. These marked-to-market 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 be subject to wide variances, must be made in mark-to-model asset valuation. Examples of mark-to-model assets are distressed debt, complex derivatives, and private equity shares.