What Are Mark-To-Market Losses?
Mark-to-market losses are losses generated through an accounting entry rather than the actual sale of a security. Mark-to-market losses can occur when financial instruments held are valued at the current market value. If a security was purchased at a certain price and the market price later fell, the holder would have an unrealized loss, and marking the security down to the new market price would result in the mark-to-market loss. Mark-to-market accounting is part of the concept of fair value accounting, which attempts to give investors more transparent and relevant information.
- Mark-to-market losses are losses generated through an accounting entry rather than the actual sale of a security.
- Mark-to-market losses can occur when financial instruments held are valued at the current market value.
- Assets that experience a price decline from their original cost would be revalued at the new market price leading to a mark-to-market loss.
Understanding Mark-To-Market Losses
Mark-to-market is designed to provide the current market value of a company's assets by comparing the value of the assets to the asset's value under current market conditions. Many assets fluctuate in value, and periodically, corporations must revalue their assets given the changing market conditions. Examples of these assets that have market-based prices include stocks, bonds, residential homes, and commercial real estate.
Mark-to-market helps to show a company's current financial condition within the backdrop of current market conditions. As a result, mark-to-market can often provide a more accurate measurement or valuation of a company's assets and investments.
Mark-to-market is an accounting method that stands in contrast with historical cost accounting, which would use the asset's original cost to calculate its valuation. In other words, historical cost would allow a bank or company to maintain the same value for an asset for its entire useful life. However, assets that are valued using market-based pricing tend to fluctuate in value. These assets don't maintain the same value as their original purchase price, which makes mark-to-market important since it revalues the assets at current prices. Unfortunately, if an asset's price decreased since the original purchase, the company or bank would need to record a mark-to-market loss.
Mark-to-market, as an accounting concept, has been governed by the Financial Accounting Standards Board (FASB), which establishes the accounting and financial reporting standards for corporations and nonprofit organizations in the United States. FASB issues its standards via the board's various statements.
Although there are many FASB statements of interest to companies, SFAS 157–Fair Value Measurements holds the most attention of auditors and accountants. SFAS 157 provides a definition of "fair value" and how to measure it in accordance with generally accepted accounting principles (GAAP).
Fair value, in theory, is equivalent to the current market price of an asset. According to SFAS 157, the fair value of an asset (as well as liability) is "the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date."
Such assets fall under Level 1 of the hierarchy created by the FASB. Level 1 assets are assets that have a reliable, transparent, fair market value, which are easily observable. Stocks, bonds, and funds containing a basket of securities would be included in Level 1 since the assets can easily have a mark-to-market mechanism for establishing its fair market value.
If the market values of securities in a portfolio fall, then mark-to-market losses would have to be recorded even if they were not sold. The prevailing values at measurement date would be used to mark the securities.
Other FASB statements include:
- SFAS 115 - Accounting for Certain Investments in Debt and Equity Securities
- SFAS 130 - Reporting Other Comprehensive Income
- SFAS 133 - Accounting for Derivative Instruments and Hedging Activities
- SFAS 155 - Accounting for Certain Hybrid Financial Instruments
Market-To-Market Losses During Crises
The purpose of the mark-to-market methodology is to give investors a more accurate picture of the value of a company's assets. During normal economic times, the accounting rule is followed routinely without any issues.
However, during the depths of the financial crisis in 2008-2009, mark-to-market accounting came under fire. Banks, investment funds, and other financial institutions held mortgages as well as mortgage-backed securities (MBS), which are a basket of mortgage loans sold to investors as a fund. These securities were held on bank balance sheets but couldn't be valued properly because the housing market had crashed.
Since there was no market for these assets any longer, their prices plummeted. And since financial institutions couldn't sell the assets, which were considered toxic at that point, bank balance sheets took on major financial losses when they had to mark-to-market the assets at the current market prices.
It turned out that banks and private equity firms that were blamed to varying degrees were extremely reluctant to mark their holdings to market. They held out as long as they could, as it was in their interest to do so (their jobs and compensation were at stake), but eventually, the billions of dollars worth of subprime mortgage loans and securities were revalued. The mark-to-market losses led to write-downs by banks, meaning the assets were revalued at fair value leading to recorded losses for banks, which totaled nearly $2 trillion. The result was financial and economic chaos.
It's important to note that market-based measurements of assets don't always reflect the true value of the asset if the price is fluctuating wildly. Also, in times of illiquidity–meaning there are few buyers or sellers–there isn't any market or buying interest for these assets, which depresses the prices even further exacerbating the mark-to-market losses.
Real World Example of Market-To-Market Losses
The 2008 and 2009 financial crisis sent the equity and real estate markets into free fall. Banks had to revalue their books to reflect the current prices of their assets at that time.
The mark-to-market losses that ensued was significant. State Street Bank is an institutional investment bank. In January 2009, the bank reported unrealized mark-to-market losses of $6.3 billion for their investment portfolio, which was an increase of $3.0 billion in mark-to-market losses recorded during their previous earnings report on September 30, 2008.
State Street Chief Executive Ron Logue (in 2009), in his interview with Reuters, said that the bank's recent stock price decline was linked “to the story of unrealized investment losses, which is so overpowering.” Mr. Logue went onto to say that the problems stemmed from a lack of liquidity in the market caused by the financial crisis and that bad credit or bad loans were not to blame.