Mark to Market... Mark to Model... Mark to Hope...
From
the International Association of Risk and Compliance Professionals
(IARCP)
What is
Mark to Market
Accounting (or Fair Value Accounting)
Mark-to-market (MTM) is the
valuation of assets at their current market
price.
Companies value assets that are
on their balance sheets according to the market price, or the latest
market indicators of the price that those
assets could be sold for immediately.
Mutual funds that
own stocks mark to market and report the value every day. Publicly
held firms mark to market each quarter.
Once upon a time all asset could have a mark to market value. In recent
years, we have derivatives or financial instruments for which book
valuation is simply impossible.
On the positive side
Mark-to-market
is the most honest and real way to price assets.
On the negative side
1. Today we can value according to the current market price, and use
it as a basis to make informed decisions. But
there is no guarantee that future transactions will realize similar
values.
2. If an asset is
trading in small quantities, marking to market is more meaningful. A
firm with a large position in that
asset can not really mark to market, as the more it sells, the more
the price declines.
3. If the markets are
not liquid, establishing a market price
is not easy.
4. The
market value is not always reflecting the
real value. In a market crisis panic
leads to very low prices.
5. The market
crisis of 2007 is caused by mark-to-market
accounting in an illiquid market.
Let's follow what has happened:
We have
declining housing prices...
... that
reduce the value NOT ONLY of
defaulting mortgages...
...
but ALL mortgages and all
mortgage-related securities...
... because
the market-bottom prices become the new standard
for the valuation of all similar securities held by all firms under
mark-to-market.
Foreclosures depress housing
prices...
...
capital values decline...
...
banks try to maintain the
capital required by regulation and fail...
...
balance sheets under
mark-to-market start to show insolvency...
...
banks begin
fire sales of assets to
raise capital to meet regulatory
requirements...
...
credit rating agencies see the
problem banks face and downgrade them...
...
which makes borrowing to meet
capital requirements more difficult....
...
and it can lead to a
downward death spiral for financial
institutions.
"During the 1980s, our underlying economic problems were far more
serious than the economic problems we're facing this time around.
The country's 10 largest banks were loaded up with Third World debt
that was valued in the markets at cents on the dollar.
If we had marked those loans to market prices,
virtually every one of them would have been insolvent."
William Isaac, former chairman of
the FDIC, in The Wall Street Journal
What is
Mark to Model
Accounting
Mark-to-market is the valuation
of assets at their current market price.
Mark-to-model is the valuation of assets
based on guesswork, assumptions and financial models.
Mutual funds mark
to market every day, and they have no difficulties doing that as
they hold liquid assets. But for those who hold illiquid assets or
assets for which there is no market, like mortgage-backed securities
and venture capital investments, marking to market is impossible.
The only practical valuation
technique for firms that have complex financial instruments in their
portfolio is marking to model.
Example: A firm acquires 1,000 shares
at a price of USD 100 per share. Some months later these shares are
trading at USD 60. If the firm marks to market, it must report a
loss to shareholders. If the firm marks to model, continues to value
the shares at USD 100. Only if it sells the shares will the firm
report a loss.
On the positive side
Not all securities are liquid as
shares for which anyone can look up the price at any given moment.
Mark to model accounting gives us the opportunity to value assets.
On the negative side
1. The assumptions and the use
of models that do not work can lead to mark-to-imagination or
mark-to-hope.
2.
Models break down dramatically
during abnormal times.
FASB Statement No. 157 - Fair Value
Measurements
According to the Statement No 157, fair value is a
market-based measurement, not an
entity-specific measurement. Therefore, a fair value
measurement should be determined based on the assumptions that
market participants would use in pricing the asset or liability.
As a basis for
considering market participant assumptions in fair value
measurements, this Statement establishes a fair value hierarchy that
distinguishes between
(1) market
participant assumptions developed based on market data obtained from
sources independent of the reporting entity (observable inputs) and
(2) the reporting
entity’s own assumptions about market participant assumptions
developed based on the best information available in the
circumstances (unobservable inputs).
The notion of
unobservable inputs is intended to
allow for situations in which there is little,
if any, market activity for the asset or liability at the
measurement date.
In those
situations, the reporting entity need not undertake all possible
efforts to obtain information about market participant assumptions.
However, the
reporting entity must not ignore information about market
participant assumptions that is reasonably available without undue
cost and effort.
This Statement clarifies that market
participant assumptions include assumptions about risk, for
example, the risk inherent in a particular valuation technique used
to measure fair value (such as a pricing model) and/or the risk
inherent in the inputs to the valuation technique.
A fair value
measurement should include an adjustment for risk if market
participants would include one in pricing the related asset or
liability, even if the adjustment is difficult to determine.
Therefore, a
measurement (for example, a mark-to-model
measurement) that does not
include an adjustment for risk would not
represent a fair value measurement if market participants would
include one in pricing the related asset or liability.
This Statement clarifies that market participant assumptions also
include assumptions about the effect of a restriction on the sale or
use of an asset.
A fair value
measurement for a restricted asset should consider the effect of the
restriction if market participants would consider the effect of the
restriction in pricing the asset.
The
International Association of Risk and Compliance Professionals (IARCP)
offers
two risk and compliance certifications:
A. Certified Risk and Compliance
Professional (CRCP)
B. Certified Information Systems Risk and Compliance Professional
(CISRCP)
To prepare for
these certifications, the
International Association of Risk and
Compliance Professionals (IARCP)
offers two
certified training courses:
A.
Certified Risk and
Compliance Professional (CRCP) - Prep Course (5 days)
B.
Certified Information
Systems Risk and Compliance Professional (CISRCP) - Prep Course (5
days)
Earning one of the
above certifications provides evidence that you possess a vast base
of knowledge.
The exams are online
To learn more you
may visit
the
Certified Risk and Compliance Training
pages of the
International Association of Risk and Compliance Professionals
(IARCP)
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