Coase-Sandor Working Paper Series in Law and Economics

Publication Date

2009

Publication Title

Law & Economics Working Papers

Abstract

Mark-to-market accounting helps create asset bubbles and exacerbate their negative collateral consequences when they burst. It does the latter by forcing the hand of counterparties to demand collateral even when it is inefficient to do so. Watchful waiting and inaction is often the more efficient course of action. Yet often this is the road not taken, out of fear of litigation and regulatory sanctions. Nonetheless, as a business matter, forbearance on foreclosure may well make sense if the party is optimistic about future values and a collateral call would generate assets sales that, under present mark-to-market rules, would negatively impact these values. But if the party forbears and is wrong about the future values, shareholders may sue the firm for not exercising its legal rights in order to protect their interests. Because future values are uncertain, litigation costs are high, and courts are likely to make some mistakes, firms will demand excessive levels of collateral. In this environment, the high transaction costs of coordination and fear of potential antitrust liability can combine to cause a rush to seize or demand collateral, even when collective forbearance would be more efficient. These problems of imperfect litigation and antitrust rules will sometimes cause action to be taken when inaction would be the more efficient course. Deleveraging cascades will result, thereby increasing the risk of financial meltdown. This article explores these and other issues surrounding the mark-to-market controversy. No system of valuing a firm's assets and liabilities is perfect, so our critique of mark to market does not clinch the case for the reinstating historical cost accounting. Rather our goal is to simply point out previously unrecognized problems with mark to market, based on their interaction with the legal system. Armed with an understanding of how litigation risk can influence market participants' behavior under different valuation rules may help standard setters in the industry modify the existing rules to reduce the chance of future market meltdowns.

Number

458

Included in

Law Commons

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