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The practice of valuation by marking-to-market with current trading prices isseriously flawed. Under leverage the problem is particularly dramatic: due tothe concave form of market impact, selling always initially causes the expectedleverage to increase. There is a critical leverage above which it is impossibleto exit a portfolio without leverage going to infinity and bankruptcy becominglikely. Standard risk-management methods give no warning of this problem, whicheasily occurs for aggressively leveraged positions in illiquid markets. Wepropose an alternative accounting procedure based on the estimated marketimpact of liquidation that removes the illusion of profit. This should curb theleverage cycle and contribute to an enhanced stability of financial markets.

A proposal for impact-adjusted valuation: Critical leverage and execution risk