Unfair 'Fair Value' in an Opaque Credit Default Swap Market: How Marking-to-Market Pushed the International Credit Crunch

Mark-to-market accounting, as required by FAS No. 157, has been implicated as a contributor to the financial meltdown caused by the housing crisis and the consequent write-down of securities backed by mortgages (MBS) and collateralized debt obligations (CDO). In this paper, we investigate the effects of mark-to-market accounting write-downs by financial institutions on equity returns, trading volume, and CDS premiums and whether the write-downs induced contagion effects on similar institutions without write-downs. Specifically, we examine whether equity returns and CDS premiums of the similar institutions responded significantly to write downs by peer firms. We find that firms that write down assets to their exit values in accordance with FAS No. 157 not only experience significant abnormal negative returns and a spike in the premiums of CDS written on their obligations – indicating higher default probability – but that similar firms without write downs exhibit a sympathetic and significant negative abnormal returns as well at the same time as the write-down firms. This is clear evidence of contagion effects induced by FAS No. 157 mark-to-market accounting. The analysis shows significant cross-sectional determinants of both equity abnormal returns and CDS premiums to generally include the measurement levels under FAS 157, liquidity, the amount of the write-down and rating changes.