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Did Capital Requirements and Fair Value Accounting Spark Fire Sales in Distressed Mortgage-Backed Securities?

Fisher College of Business Working Paper No. 2012-03-12

Charles A. Dice Center Working Paper No. 2012-12

47 Pages Posted: 24 Jul 2012 Last revised: 10 Feb 2013

Craig B. Merrill

Brigham Young University; Wharton Financial Institutions Center

Taylor Nadauld

Brigham Young University

René M. Stulz

Ohio State University (OSU) - Department of Finance; National Bureau of Economic Research (NBER); European Corporate Governance Institute (ECGI)

Shane M. Sherlund

Federal Reserve Board of Governors

Multiple version iconThere are 2 versions of this paper

Date Written: July 23, 2012

Abstract

Much attention has been paid to the large decreases in value of non-agency residential mortgage-backed securities (RMBS) during the financial crisis. Many observers have argued that the fall in prices was partly driven by decreased liquidity and fire sales. We investigate whether capital requirements and accounting rules at financial institutions contributed to the selling of RMBS at fire sale prices. For financial institutions subject to credit-sensitive capital requirements, capital requirements increase as an asset’s credit becomes impaired. When accounting rules require such an asset’s value to be marked-to-market and the fair value loss to be recognized in earnings, a capital-constrained firm can improve its capital position by selling the credit-impaired asset even if it has to accept a liquidity discount to do so. Using a sample of 5,014 repeat transactions of non-agency RMBS by insurance companies from 2006 to 2009, we show that insurance companies that became more capital-constrained because of operating losses (uncorrelated with RMBS credit quality) and also recognized fair value losses sold comparable RMBS at much lower prices than other insurance companies during the crisis.

Keywords: Mark-to-market accounting, capital requirements, RMBS, fire sale, financial crisis

JEL Classification: G22, G28, G32, M41

Suggested Citation

Merrill, Craig B. and Nadauld, Taylor and Stulz, René M. and Sherlund, Shane M., Did Capital Requirements and Fair Value Accounting Spark Fire Sales in Distressed Mortgage-Backed Securities? (July 23, 2012). Fisher College of Business Working Paper No. 2012-03-12. Available at SSRN: https://ssrn.com/abstract=2115537 or http://dx.doi.org/10.2139/ssrn.2115537

Craig B. Merrill

Brigham Young University ( email )

Provo, UT 84602
United States
(801) 422-4782 (Phone)

Wharton Financial Institutions Center ( email )

2306 Steinberg Hall-Dietrich Hall
3620 Locust Walk
Philadelphia, PA 19104
United States

Taylor Nadauld

Brigham Young University ( email )

Provo, UT 84602
United States

Rene M. Stulz (Contact Author)

Ohio State University (OSU) - Department of Finance ( email )

2100 Neil Avenue
Columbus, OH 43210-1144
United States

HOME PAGE: http://www.cob.ohio-state.edu/fin/faculty/stulz

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

European Corporate Governance Institute (ECGI)

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

Shane M. Sherlund

Federal Reserve Board of Governors ( email )

20th and C Streets, NW
Mailstop 93
Washington, DC 20551
United States
202-452-3589 (Phone)
202-728-5887 (Fax)

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