Marking to Market: Can Accounting Rules Shake the Foundations of Capitalism?

Mark-to-market accounting helps create asset bubbles and exacerbate their negative collateral consequences when they burst. It does the latter by forcing the hand of counterparties to demand collateral even when it is inefficient to do so. Watchful waiting and inaction is often the more efficient course of action. Yet often this is the road not taken, out of fear of litigation and regulatory sanctions. Nonetheless, as a business matter, forbearance on foreclosure may well make sense if the party is optimistic about future values and a collateral call would generate assets sales that, under present mark-to-market rules, would negatively impact these values. But if the party forbears and is wrong about the future values, shareholders may sue the firm for not exercising its legal rights in order to protect their interests. Because future values are uncertain, litigation costs are high, and courts are likely to make some mistakes, firms will demand excessive levels of collateral. In this environment, the high transaction costs of coordination and fear of potential antitrust liability can combine to cause a rush to seize or demand collateral, even when collective forbearance would be more efficient. These problems of imperfect litigation and antitrust rules will sometimes cause action to be taken when inaction would be the more efficient course. Deleveraging cascades will result, thereby increasing the risk of financial meltdown. This article explores these and other issues surrounding the mark-tomarket controversy. No system of valuing a firm’s assets and liabilities is perfect, so our critique of mark to market does not clinch the case for the reinstating historical cost accounting. Rather our goal is to simply point out previously unrecognized problems with mark to market, based on their interaction with the legal system. Armed with an understanding of how litigation risk can influence market participants’ behavior under different valuation rules may help standard setters in the industry modify the existing rules to reduce the chance of future market meltdowns. * James Parker Hall Distinguished Service Professor of Law, the University of Chicago Law School, Peter and Kirsten Bedford Senior Fellow, The Hoover Institution, and visiting professor New York University Law School; Assistant Professor of Law, the University of Chicago Law School respectively. We thank Douglas Baird, Dan Currell, Jens Dammann, Christian Leuz, Saul Levmore, Jonathan Masur, and James Spindler for their valuable comments. 2 / Epstein and Henderson ”There is no such uncertainty as a sure thing.”†