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Mark to Market and the Equity Premium

Call this the dept. of unanticipated consequences. Regulators have encouraged financial institutions to adopt ‘mark-to-market’ accounting, in the interest of greater transparency. And that’s partly why we’ve seen such big write downs on Wall Street.

But there’s a side-effect. ‘Mark to market’ makes fixed income securities behave like equities. That is, we can have big swings in value even if the flow of income doesn’t change very much. (Just like stocks can change in value even if the dividends don’t change).

Here’s the thing. We all know that investors demand a substantial “equity premium” for investing in stocks. There’s no consensus why—it could be for psychological reasons, it could be because investors fear rare horrible events, or it could be for some other reason. But the equity premium seems to be a stable part of the financial markets.

Let’s get inside the head of investors. If they see the ‘mark-to-market’ value of mortgage-backed securities plunge, all of a sudden they may put the securities into the ‘equity’ category in their mind, rather than the ‘fixed income’ category. As a result, they demand a sharply higher return—much more than the increase in risk would seem to warrant.

This shift from ‘fixed income’ to ‘equities’ may help explain the freeze-up in the credit markets.

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