Mark-to-Market and the Tragedy of the Commons

Going back to accounting 101.

The accounting worth of a company, or its equity, is assets minus liabilities.

So if Acme Inc has $100 worth of equipments and owes someone $80, then its "worth" is $20.

(Let's pretend there aren't messy little things such as stocks that mucks up the neat little world above.)

Now in the example above, we simply assumed that the equipment is worth $100. In the world of actual things, we might come to that value after some sort of amortization and depreciation- you bought the machine last year at $150, it's worth $100 now because you expect it to last 3 years. Or something.

In the financial world, where most of the assets are not tangible things, they are valued in a mark-to-market fashion. Using the same example as above. Suppose last year Acme Inc paid $100 for one bond. Let's say that same bond is now trading at $110 in the open market. That means Acme Inc now is "worth" $30 ($110-80) instead of $20.

That's all nice and pretty, but here's the kicker- what if the price of that bond is highly volatile? Let's suppose that same bond all-of-a-sudden trades at $70. Oops, Acme Inc is now all of a sudden insolvent ($70-$80= negative equity!) on paper, even if hypothetically it knows that the price will come back up tomorrow. Now if you are forced to liquidate anytime you have negative equity on paper, then you are guaranteed to go under even if you have a little bit of liability- if the asset in question has some sort of a fat-tail distribution. It's analogous to the play-to-extinction dynamics in gambling that gives the house the edge.

This relates to an off-handed comment from a coworker, who mentioned that a lot of research has gone into see just how mark-to-market accounting leads to greater systemic instability.

What does that have to do with the tragedy of the commons argument? It makes me wonder to what extent does mark-to-market becomes a transmission mechanism for negative externalities. For example, if someone runs up the market price by foolishly overbidding it, will this tomfoolery led to more economic instability in a M2M world than it otherwise would in a historical cost world?