This paper examines the relative strength of two imperfect accounting rules: historical cost and mark to market. The manifest inaccuracy of historical cost is well known, and, paradoxically one source of its hidden strength. Because private parties know of its evident weaknesses they look elsewhere for information. In contrast, mark to market for hard-to-value assets has many hidden weaknesses. In this paper we show how it creates asset bubbles and exacerbate their negative collateral consequences once they burst. It does the former by allowing banks to adopt generous valuations in up-markets that increase their lending capacity. It does the latter by forcing the hand of counterparties to demand collateral even when watchful waiting and inaction is the more efficient course of action when the downward cascades generated by mark-to-market accounting may trigger massive sell-offs at prices below true asset value. The fears of private suits and regulatory sanctions on counterparties can compound the problem. Mark to market generates the functional equivalent of bank runs for which the functional equivalent of the automatic-stay rule in bankruptcy is the appropriate response.
Available at: http://works.bepress.com/todd_henderson/7/