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This article argues that fair-market value accounting could have played a significant role in the recent financial crisis, by causing a drop in demand for the structured finance products that were central to the market collapse. The culprit is the discretion inherent in the use of "mark-to-model" reports, in which firms report fair values that they calculate internally, rather than actual market prices. In equilibrium, discretion in mark-to-model reports leads to aggressive reporting of asset values, compared with a conservative reporting regime. Aggressive reporting weakens demand and increases financial market frictions, resulting in illiquidity. We demonstrate these effects in a laboratory experiment with a matched pairs design, and find that adopting a mark-to-model regime causes drops in prices and reduces the frequency of trade. |
