Why Were There Fire Sales of Mortgage-Backed Securities by Financial Institutions during the Financial Crisis?

Charles A. Dice Center Working Paper No. 2013-02

Fisher College of Business Working Paper No. 2013-03-02

57 Pages Posted: 26 Feb 2013 Last revised: 15 May 2014

See all articles by Craig B. Merrill

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

Date Written: December 1, 2013

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 caused by fire sales. We use capital requirements and accounting rules to identify circumstances where financial institutions had incentives to engage in fire sales and then examine whether such sales occurred. 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. In contrast, a financial firm whose fair value losses are not recognized in earnings for the purpose of calculating capital requirements is more likely to satisfy capital requirements by selling liquid assets whose value has not fallen and hence would be unlikely to engage in fire sales. Using a sample of 5,000 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: Fire sale, RMBS, capital requirements, fair value, financial crisis

JEL Classification: G01, G21, G22, G23, M41

Suggested Citation

Merrill, Craig B. and Nadauld, Taylor and Stulz, Rene M. and Sherlund, Shane M., Why Were There Fire Sales of Mortgage-Backed Securities by Financial Institutions during the Financial Crisis? (December 1, 2013). Charles A. Dice Center Working Paper No. 2013-02; Fisher College of Business Working Paper No. 2013-03-02. Available at SSRN: https://ssrn.com/abstract=2212684 or http://dx.doi.org/10.2139/ssrn.2212684

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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