Mark to Market: Understanding Valuation

Essentially a fancy way of saying how much something is worth, mark-to-market (MTM) is an accounting method for valuation of assets and liabilities. Let’s start with a few definitions and then explore why we care about MTM.

Definitions: 

• Valuation or “Fair Value” - the price at which an asset can be sold or settled today, given today’s economic and related variables taken into consideration.  

• MTM Accounting Treatment - the treatment of recognizing gains and losses on the financial statement as they occur, as opposed to when the asset is sold.  This means that both paper (i.e., unrecognized) gains and losses are settled for accounting purposes each year for assets held. 

I started exploring the concepts of MTM for three reasons. First, I wanted to see if it would be advantageous to have my stock and options trading activities be treated as MTM along with an IRS designation for an active trader. Second, I became interested in the concept after learning that Private Equity is not using MTM to value their assets and investors may be facing lower actual valuations in the future.  And third, I wanted to learn more about MTM for Real Estate-related assets and how that MTM treatment could potentially create a self-fulfilling prophecy during market drawdowns leading to exaggerated devaluations and trigger forced selling.

With regard to stock and option trading, I researched MTM to see if that designation would be helpful in optimizing my tax expenses. Without MTM designation for trading, I would be subject to different tax rates for both long-term and short-term long gains/losses. Specifically, for gains generated for sales held more than 12 months, I would receive a lower long-term capital gain rate.  Short-term gain, or gains on sales held less than 12 months, would be taxed at a materially higher marginal tax rate.  However, losses in the short-term would face a limit in off-setting taxable short-term gains, potentially leading to an unfavorable tax situation. The option people have is to elect MTM treatment which would allow for the full off-set between short-term losses and gains, but the individual would lose the more favorable long-term tax treatment. Upon further research and analysis, I have decided to wait on changing my tax treatment for equities trading to MTM so that I can maximize my previously established long-term capital gain tax strategies.

Mark-to-market related to private equity markets has been interesting to me both from a psychology perspective and a behavioral economics perspective. A piece published by Patrick Boyle in 2023 titled “Blackstone’s Investors Want Their Money Back!”, satirically noted that the self-assessed valuations of real estate held in private equity vehicles had not seen the same drawdown every other real estate holding in the country did. But due to the fact that you could not sell you position even if you wanted to, no actual transactions would take place and the real losses an investor would face, would therefore not be realized. As Mr. Boyle put it, maybe some investors would prefer to brag of fake unrealized gains to their friends and not have to deal with the emotional toll a paper loss would place on them if they followed true MTM.  Or is it that investors cannot be trusted to stay the course when a drawdown occurs and by locking the exit, the private equity firms are helping protect investors from their own ill-advised actions of selling at a loss and missing out on the subsequent ascent of valuation?  

I believe I witnessed an unintended consequence of mark-to-market on real estate. Specifically, the change around real estate accounting rules known as Financial Accounting Standards (FAS) 157. FAS 157 took effect in November of 2007 and required financial institutions to value certain assets, including real estate, at their current market value. The way I understand it, under this rule, banks would need to re-assess the value of real estate; real estate upon which debt instruments were derived by the bank.  This mark-to-market reassessment of the value, when values of real estate were depressed, would result in the banks requiring additional capital from the borrower such that they could maintain debt-to-equity ratios outlined in debt covenants between the borrower and lender. In other words, the party who borrowed to buy the land and building for the pizza parlor and the bakery next door, would immediately need to provide additional money to make up the difference in the shortfall now that the properties value had gone down. Well, the pizza shop and baker were unable to make the additional payments, resulting in foreclosure by the bank, and the pizza parlor and bakery next door now being vacant.  These increased vacancies drives the prices of other real estate down as well, creating a vicious feedback loop that causes further price depression, leading to additional defaults, again leading to further price depression. This market-to-market change in 2007 may have accelerated the 2008 financial crisis; albeit there were many other causes and factors than just MTM.

So what I have taken away from the MTM concept is that:

1. MTM impacts stock and options traders via relationships between short term gain and loss tax treatments; however will also impact long-term gain and loss treatment so its not a clear cut case for or against the discretionary MTM treatment.  

2. MTM in an illiquid asset such as in the case of private equity limited partnerships, can result in inflation of stated asset values in excess of the price at which the market is transacting similar assets (e.g., house A and B are the same size, quality and relative location, but the PE house A is valued materially higher than the open market value of house B that just sold).

3. MTM impacts real estate via feedback loops wired into the banking borrower-lender agreements that can cause violent price crashes that ripple into trouble for other borrowers and lenders seemingly unrelated to one another.