What is Mark-To-Model
Mark-to-model is a pricing method for a specific investment position or portfolio based on internal assumptions or financial models. This contrasts with traditional mark-to-market valuations, in which market prices are used to calculate values as well as the losses or gains on positions. Assets that must be marked-to-model either don't have a regular market that provides accurate pricing, or valuations rely on a complex set of reference variables and timeframes. This creates a situation in which guesswork and assumptions must be used to assign value to an asset.
BREAKING DOWN Mark-To-Model
Mark-to-model assets essentially leave themselves open to interpretation, and this can create risk for investors. The dangers of mark-to-model assets occurred during the subprime mortgage meltdown beginning in 2007. Billions of dollars in securitized mortgage assets had to be written off on company balance sheets because the valuation assumptions turned out to be inaccurate. Many of the mark-to-model valuations assumed liquid and orderly secondary markets and historical default levels. These assumptions proved wrong when secondary liquidity dried up and mortgage default rates spiked well above normal levels.
Largely as a result of the balance sheet problems faced with securitized mortgage products, the Financial Accounting Standards Board (FASB) issued a statement in November of 2007 requiring all publicly traded companies to disclose any assets on their balance sheets that rely on mark-to-model valuations beginning in the 2008 fiscal year.
Level 1, Level 2 and Level 3
FASB Statement 157 introduced a classification system that aims to bring clarity to financial asset holdings of corporations. Assets (as well as liabilities) are divided into three categories — Level 1, Level 2 and Level 3. Level 1 assets are valued according to observable market prices. These marked-to-market assets include Treasury securities, marketable securities, foreign currencies, commodities and other liquid assets for which current market prices can be readily obtained. Level 2 assets are valued based on quoted prices in inactive markets and/or indirectly rely on observable inputs such as interest rates, default rates and yield curves. Corporate bonds, bank loans and over-the-counter derivatives fall into this category. Finally, Level 3 assets are valued with internal models. Prices are not directly observable and assumptions, which can be subject to wide variances, must be made in mark-to-model asset valuation. Examples of mark-to-model assets are distressed debt, complex derivatives and private equity shares.