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usefulness of AAA-rated PMBS as assets that Bear and others relied on for both
capital and liquidity, and thus raised questions about the fi rm’s ability to meet its
obligations. Investment banks like Bear Stearns were not commercial banks; instead
of using short term deposits to hold long term assets—the hallmark of a bank—
their business model relied on short-term funding to carry the short term assets
of a trading business. Contrary to the views of the Commission majority, there is
nothing inherently wrong with that business model, but it could not survive an
unprecedented fi nancial panic as severe as that which followed the collapse in value
of an asset class as large and as liquid as AAA-rated subprime PMBS.

Mortgage Defaults at Record Rates Created Balance Sheet Losses
Chairman Bair also pointed to the relationship between the decline in the
value of PMBS and “the balance sheet strength” of fi nancial institutions that held
these assets. Adding to liquidity-based losses, balance sheet writedowns were
another major element of the loss transmission mechanism. Securitized assets held
by fi nancial institutions are subject to the rules of fair value accounting, and must
be marked to market under certain circumstances. Th us, banks and other fi nancial
institutions that are holding securitized mortgages in the form of PMBS could
be subject to large accounting losses—but not necessarily cash losses—if investor
sentiment were to turn against securitized mortgages and market values decline.
Accordingly, once large numbers of delinquencies and losses started showing up in
the mortgage markets generally and in the mortgage pools that backed the PMBS,
it was not necessary for all the losses to be realized before the PMBS lost substantial
value. All that was necessary was that the market for these assets become seriously
impaired. Th is is exactly what happened in the middle of 2007, leading immediately
not only to severe adverse liquidity consequences for fi nancial institutions that held
PMBS but also to capital writedowns that made them appear unstable and possibly
insolvent.
Th ese mark-to-market capital losses could be greater than the actual
credit losses to be anticipated. As one Federal Reserve study put it, “Th e fi nancial
turmoil…put downward pressure on prices of structured fi nance products across
the whole spectrum of [asset-backed] securities, even those with only minimal ties
to the riskiest underlying assets…[I]n addition to discounts from higher expected
credit risk, large mark-to-market discounts are generated by uncertainty about the
quality of the underlying assets, by illiquidity, and by price volatility…Th is illiquidity
discount is the main reason why the mark-to-market discount here, and in most
similar analyses, is larger than the expected credit default rates on underlying
assets.” In other words, the illiquidity discount associated with the uncertainties in
52
value of collateral are and can be substantially larger than the credit default spread,
since the spread refl ects only anticipated credit losses.
As shown so dramatically in Figure 3, the collapse of the market for PMBS
was a seminal event in the history of the fi nancial crisis. Even though delinquencies
had only just begun to show up in mortgage pools, the absence of a functioning

52 Daniel Beltran, Laurie Pounder and Charles Th omas, “Foreign Exposure to Asset-Backed Securities of
U.S. Origin,” Board of Governors of the Federal Reserve System, International Finance Discussion Papers
939, August 2008, pp. 11-14.