Mark to Market... Mark to
Model... Mark to Hope...
International Association of Risk and Compliance Professionals
(IARCP)
Revisions to the Basel II market risk
framework, BIS February 2011
718(civ). Banks
must mark-to-market as much as possible
718(cv). Only where marking-to-market is not possible, should
banks mark-to-model, but this must be demonstrated to be prudent
718(cv). Supervisory authorities will consider the following in
assessing whether a mark-to-model valuation
is prudent:
- Senior
management should be aware of the elements of the trading book
or of other fair-valued positions which are
subject to mark to model and should understand the materiality
of the uncertainty this creates in the reporting of the
risk/performance of the business.
-
Market inputs should be sourced, to
the extent possible, in line with market prices (as discussed above).
The appropriateness of the market inputs for the particular position
being valued should be reviewed regularly.
- Where
available, generally accepted valuation methodologies for particular
products should be used as far as possible.
- Where the
model is developed by the institution itself, it should be based on
appropriate assumptions, which have been assessed and challenged by
suitably qualified parties independent of the development process.
The model should be developed or approved
independently of the front office. It should be independently
tested. This includes validating the mathematics, the assumptions and
the software implementation.
- There should be formal
change control procedures in place and a secure copy of the model
should be held and periodically used to check valuations.
-
Risk management should be aware of the weaknesses of the models used
and how best to reflect those in the valuation output.
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.
"A second downside of
the increased reliance on securitisation has to do with
valuation issues.
Valuation
of such products requires information that may not be available or may
be hard to interpret.
Consider, for example, the information
deficit with respect to the US subprime mortgage market.
Not only were many loans undocumented, but
much of the information provided was clearly fraudulent.
Furthermore, the data used to calibrate all valuation models were
generally of very recent vintage, failing to cover one complete credit
cycle. And inadequate data is not the only problem.
Consider
as well the sensitivity of valuation methodologies to assumptions
about the possibility of default, loss-given-default, default
correlations, and the relationships between all of the above.
Work by two of my colleagues at the BIS shows that
such errors in calibrations can have
first-order effects on “mark to model” evaluations.
Finally, we know that correlations based on historical data move
around enormously, in part because (as Green and Wachter rightly
stress) household behaviour can in fact change significantly over
time.
Taken all together, there are
formidable technical obstacles to getting “mark to model” evaluations
right, particularly for complex products.
[From the
housing finance revolution, discussion of paper by R Green and S
Wachter by Mr William R White, Economic Adviser and Head of the
Monetary and Economic Department of the BIS, at "Housing, housing
finance and monetary policy" symposium]
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