Mark to market is an accounting method that values an asset to its current market level. It shows how much a company would receive if it sold the asset today. It is also called fair value accounting or market-value accounting for that reason. It is similar to the substitute value in your insurance policy.
The alternative approach is called accounting of the historical costs. It keeps the value of the asset to its original level on the books. It’s kind of like insuring your car’s depreciated worth.
How does it work
At the end of each fiscal year, a corporation will declare how much each asset is worth in its financial statements. It’s easy for accountants to estimate the market value if traders buy and sell that type of asset often.
The 10 year Treasury Note is a perfect example. An accountant repays the asset according to the market quoted rate. When the rate of return on the Treasury increased throughout the year, the accountant must mark the value of the notes down. The notice the bank holds will not cost in interest as much as new bills. If the company sells the loan, they would earn less than they charged for it. Every business day the Treasury Notes values are reported in the financial papers.
A controller can choose from two other approaches to estimate the value of the illiquid assets. The first approach is called default risk. It incorporates the probability of the asset not valuing its original value. In a home mortgage, a borrower’s credit score will be reviewed by an accountant. If the score is low, then there is a greater chance that the mortgage will not be repaid. The accountant will discount the original value by the percentage of defaulting on the borrower.
The second form is known as interest rate risk. Compared to similar assets it incorporates the value of the assets. For instance, claim that asset is a bond. When interest rates increase, then mark the bond down. Potential investors will pay less for a lower-yield bond. Yet this bond does not have a liquid market like there are for Treasury bonds. Consequently, an accountant will continue with the valuation of the bond based on the Treasury notes. He will lower the value of the bond, based on its risk as calculated by a credit rating of Good and Poor.
Pros and cons of Mark to Market
Mark to market gives an exact picture of the current value of an asset. Investors need to learn if the value of a company’s assets has decreased. Otherwise the firm can overestimate its true net worth.
For example, the Savings and Loan Crisis may have avoided mark to market accounting. Banks used traditional accounting in the 1970s and 1980s. They only listed the initial real-estate values they bought and revised values when they sold the house.
As oil prices fell in 1986, Texas savings and loans owned land also plummeted. Yet the banks held the value of the initial price on their accounts. That made it look like the banks were in a better financial form than they had been. The banks hid their declining assets from the deteriorating state.
The Great Depression worsened with Mark to market accounting. The Federal Reserve noted that many bank failures were triggered by mark to market. Most banks were put out of business after their assets were devalued. President Roosevelt took advice from the Fed in 1938, and revoked it.
The financial crisis in 2008
The 2008 financial crisis may have exacerbated mark to market accounting. First, as housing prices skyrocketed, banks increased the rates of their mortgage-backed securities (MBS) They then scrambled to raise the amount of loans to preserve the balance between assets and liabilities that they had made. They eased down on credit requirements in their desperation to sell more mortgages. They loaded onto subprime mortgages as a result. This was one reason this derivatives exacerbated the mortgage crisis.
The second issue emerged when rates for assets started to decline. Mark to market accounting obliged banks to write down their subprime debt prices. Now the banks wanted less to lend to ensure that their liabilities were not greater than their assets. Mark to market inflated the housing bubble during the recession, and deflated home prices.
The U.S. In 2009 The Board of Financial Accounting Standards eased the mark on market accounting regulation. This suspension allowed banks to maintain the MBS values on their books. The prices had completely collapsed.
Unless the banks were required to mark their interest down, it would have triggered the default clauses in their derivatives contracts. The contracts required credit default swaps insurance coverage when the MBS value had exceeded a certain amount. It would have taken out all of the world’s largest financial institutions.
How does this impact you?
Mark market discipline will assist you in handling your finances. To record its current value, you should check your pension portfolio monthly or quarterly.
You should meet with your financial counselor once or twice a year to rebalance your holdings. Make sure they align with the asset allocation you want. That is important in order to retain a diversified portfolio’s benefits. A counselor will assist you in assessing the right distribution based on your specific financial objectives.