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

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Author Info

  • Merrill, Craig B.

    (Brigham Young University)

  • Nadauld, Taylor

    (Brigham Young University)

  • Stulz, Rene M.

    (OH State University and European Corporate Governance Institute)

  • Sherlund, Shane M.

    (Federal Reserve Board)

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    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.

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    Bibliographic Info

    Paper provided by Ohio State University, Charles A. Dice Center for Research in Financial Economics in its series Working Paper Series with number 2012-12.

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    Date of creation: Jul 2012
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    Handle: RePEc:ecl:ohidic:2012-12

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    Cited by:
    1. Ralph S.J. Koijen & Motohiro Yogo, 2012. "The Cost of Financial Frictions for Life Insurers," NBER Working Papers 18321, National Bureau of Economic Research, Inc.

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