Monday, February 22, 2010

Does Mark-to-Market Make A Liquidity Crisis A Solvency Crisis?

The Economist (PDF):
The other brutal lesson of the crisis concerns  the way liquidity can affect solvency. In a world of mark-to-market  accounting, a small price movement on a large, illiquid portfolio  can  quickly  turn  into  crippling paper losses that  eat  into capital. Highly rated  but  hard to shift   debt  instruments can finish you before losses on the underlying loans  have  even  begun  to  hurt your  cash flows.

I remember hearing about this during the crisis, but forgot about it. Basically, the problem is that if you have to account for paper losses of assets, even if you have no intention of selling and they are still paying you returns, then the accounting rules may force you to sell the asset thereby turning a paper loss into a real one.

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