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

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  • Craig B. Merrill
  • Taylor D. Nadauld
  • René M. Stulz
  • Shane Sherlund

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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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 18270.

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Date of creation: Aug 2012
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Handle: RePEc:nbr:nberwo:18270

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  1. Shleifer, Andrei & Vishny, Robert W, 1992. " Liquidation Values and Debt Capacity: A Market Equilibrium Approach," Journal of Finance, American Finance Association, American Finance Association, vol. 47(4), pages 1343-66, September.
  2. Gary Gorton & Andrew Metrick, 2010. "Securitized Banking and the Run on Repo," NBER Chapters, National Bureau of Economic Research, Inc, in: Market Institutions and Financial Market Risk National Bureau of Economic Research, Inc.
  3. Andrei Shleifer & Robert Vishny, 2011. "Fire Sales in Finance and Macroeconomics," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 25(1), pages 29-48, Winter.
  4. Christian Laux & Christian Leuz, 2009. "Did Fair-Value Accounting Contribute to the Financial Crisis?," NBER Working Papers, National Bureau of Economic Research, Inc 15515, National Bureau of Economic Research, Inc.
  5. Lasse Heje Pederson & Markus K Brunnermeier, 2007. "Market Liquidity and Funding Liquidity," FMG Discussion Papers, Financial Markets Group dp580, Financial Markets Group.
  6. Markus K. Brunnermeier, 2009. "Deciphering the Liquidity and Credit Crunch 2007-2008," Journal of Economic Perspectives, American Economic Association, American Economic Association, vol. 23(1), pages 77-100, Winter.
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Cited by:
  1. Ralph S.J. Koijen & Motohiro Yogo, 2013. "Shadow Insurance," NBER Working Papers, National Bureau of Economic Research, Inc 19568, National Bureau of Economic Research, Inc.
  2. Koijen, Ralph S.J. & Yogo, Motohiro, 2014. "The Cost of Financial Frictions for Life Insurers," Staff Report, Federal Reserve Bank of Minneapolis 500, Federal Reserve Bank of Minneapolis.

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