What is mark to market?

Mark to market is the act of valuing an asset at its current market price, as opposed to its book price.

Primarily an accounting practice, mark to market is relevant for private investors in several ways:

• If you borrow money to invest, you could face margin calls if your account is marked to market.

• You mark to market when working out your current net worth, by estimating the value of your home and other illiquid investments.

• Discovering assets owned by listed companies that are NOT marked to market — and so are being carried on the books too cheaply — can unearth hidden value.

Some blame mark to market for the credit crisis of 2007 to 2009.

As credit markets froze up in late 2007 and trading stopped, the prices available for some securities — especially mortgage-backed securities — became hugely suspect and a very poor indicator of fair value.

Yet following the accounting rules, banks continued to revalue their holdings by marking them to market.

Because prices had fallen, their assets were now worth less, and so the banks’ reported huge quarterly losses.

Yet in many cases the assets had NOT been sold, and in most cases they were expected to be sold for higher prices or to be repaid in full (in the case of debt).

Banks had to raise more equity or sell more assets to repair their balance sheets as a result of these writedowns. Both activities further hurt sentiment and price.

Mark to market rule relaxed

While some flawed companies were certainly exposed by the sub-prime crisis, it’s arguable the panic was made far worse by marking to market.

The Washington Post wrote of mark to market:

The accounting standard, known as fair value or mark to market, has been cited as a contributing factor in the collapses of American International Group, Freddie Mac and Lehman Brothers.

Accordingly, the accounting rule was eased in April 2009:

Changes to fair-value, or mark-to-market accounting, […] allow companies to use “significant” judgment in gauging prices of some investments on their books, including mortgage-backed securities. Analysts say the measure may reduce banks’ writedowns and boost net income. Firms could apply the changes to first-quarter results.

Banking stocks rallied strongly for months after the change.

Mark to market and your portfolio

For assets that are traded regularly on open marketplaces, marking to market is very straightforward.

If you have a portfolio of listed stocks, you can find its current value simply by logging onto your broking account or by reading the Financial Times and doing some sums.

Your online broker will typically update the prices of your shares continually (albeit with a 15-minute reporting delay here in the UK).

Fund prices are updated daily.

In contrast, if you have a private pension, your provider may send you a valuation every 12 months. As far as you’re concerned, your pension is marked to market on the date of that valuation. (Between valuations, you guess!)

What if there is no market price?

Sometimes you might not know the market price of an asset unless you sell it.

• An obvious example would be the value of your house.

• An example in corporate finance would be the value of an unlisted start-up company backed by a venture capital fund.

In this case you (or the accountants) try to estimate or model the asset’s value.

This can be a complex process for the holdings of big institutions, so I’ll try to explain it simply via — get ready — pedigree cats.

Marking to market Siamese Cats

Imagine you own five pedigree Siamese cats.

You have no idea what your five cats are worth because Siamese cats aren’t listed in the Financial Times.

However you know that a Persian cat sold on eBay this morning for £100.

Now, let’s say you also know that Siamese cats normally sell for about 50% the prevailing price of Persian cats. (I have no idea if they do. It’s just an illustration.)

Inputting the recent Persian cat sale price into your Siamese Cat Price Model (i.e. Siamese cats cost half as much as Persian cats) gives you the fair value of the five cats you own:

• 5 x (£100/2)=£250

Mark to market and estimations

Sometimes there’s no accurate model for marking to market a particular asset, and so you have to be more creative.

For instance, imagine you bought your house ten years ago, and your mother-in-law wants to know what the house is worth today.

This situation is tricky, because every house is different, even in a street of similar houses. Some will be in better repair, while others may reek of Siamese cats.

You (or your estate agent) would therefore have to estimate the value of your house, by looking at the prices that other houses in your street had sold for recently, and comparing those houses to your own house.

They might also work published price trends into their estimate. For example, if the last house in your road was sold a year ago but Nationwide says prices have fallen in your area by 10% in the past six months, that will need to be taken into account.

The final figure should be fair estimate of the value of your home — but it isn’t an exact one.

Banks, insurers and other financial companies use complicated ‘black boxes’ to do the same thing for marking to market their holdings where no market price is available.

Such models are often not very transparent, and so can be controversial!