8/12/2007: Marking-to-Market: Panacea or Pandora's Box?

Excerpt from Marking-to-Market: Panacea or Pandora's Box?
By Guillaume Plantin, Haresh Sapra, and Hyun Song Shin (with Sab's comments in brackets]

Financial institutions have been at the forefront of the debate on the controversial shift in international standards from historical cost accounting to mark-to-market accounting. ... A natural remedy to the inefficiency in the historical cost regime would be to shift to a mark-to-market regime where asset values are recorded at their transaction prices. This is only an imperfect solution, however. The illiquidity of the secondary market causes another type of inefficiency. A bad outcome for the asset [for example, an increase in the default rate for mortgages backing an RMBS] will depress fundamental values somewhat, but the more pernicious effect comes from the negative externalities generated by other firms selling. When others sell, observed transaction prices are depressed more than is justified by the fundamentals, and exerts a negative effect on all others, but especially on those who have chosen to hold on to the asset. Anticipating this negative outcome, a short-horizon firm will be tempted to preempt the fall in price by selling the asset itself. However, such preemptive action will merely serve to amplify the price fall. In this way, the mark-to-market regime generates endogenous volatility of prices that impede the resource allocation role of prices.