Mark to Market and the Equity Premium

Posted by: Michael Mandel on March 10

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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Reader Comments

Forain

March 11, 2008 04:04 AM

You nailed it.
That's exactly how my fellow investors are currently reasoning and that's maybe the badest news we could ever have.
You should give a look at Richard Thaler paper about the equity premium and how the flow on information affect our judgement.
Mark to Market has one horrible consequence : shortermism, you don't dare to buy a bond (even if it is a long time maturity bond) because you are afraid to justify yourself to your boss, client, sharehoolders if the bond value drop 5% in a week.
Some people should work of the link between time horizon and premium for people with a constant normal risk aversion. You 'll get a pretty damn interesting graph which explain a lot.

Very bad news for investment because this increase in the cost of risk because of some accounting standards is very sad.

Ritholtz

March 12, 2008 06:45 AM

The substantial “equity premium” is to compensate the investor for the increased risk of equities versus the safety of guaranteed govt bonds.

There is wide consensus on that first point.

Where there is some disagreement is why the premium gets as wide as it does at times.

My answer is rooted in human psychology and emotional/adrenal responses to fear or danger -- but there is less agreement over that . . .

Joe Cushing

March 12, 2008 10:00 AM

The should be allowed to estimate defaults and calculate present value for their balance sheets instead of having to write down every swing. If they hold the bond, it will pay off eventually.

Mike Mandel

March 12, 2008 11:20 AM

Psychology works for me...and that's why mark to market is an issue.

Geoff Davis

March 9, 2009 12:17 PM

Joe Cushing is exactly right. If the bond/ note/ mortgage is paid on time and not defaulted that is one issue. If a material event occurs, than Joe's approach would maintain transparency and correct the current mess.

Thank you for your interest. This blog is no longer active.

 

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Michael Mandel, BW's award-winning chief economist, provides his unique perspective on the hot economic issues of the day. From globalization to the future of work to the ups and downs of the financial markets, Mandel-named 2006 economic journalist of the year by the World Leadership Forum-offers cutting edge analysis and commentary.

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