Schwarzman's accounting trial balloon gets thoroughly aerated

Steve Schwarzman's argument (as filtered by Andrew Sorkin) that the world would be a better place if banks didn't have to report the current market values of all that toxic junk in their portfolios has become the wonky business blogger topic of the week, inspiring posts from Felix Salmon, Barry Ritholtz, Roger Ehrenberg, Yves Smith, Tom Selling, James Mackintosh, and, well, who am I forgetting?

Schwarzman--channeling a whole lotta people in the banking business these days--argues that “the concept of fair value accounting is correct and useful, but the application during periods of crisis is problematic.” Financial angst is driving the prices of many debt securities way below their real value, he argues, causing banks write down their portfolios excessively and sharply cut back on new lending.

The consensus of the blogosphere is that this is a load of self-serving nonsense (although Selling, an actual CPA, isn't so thrilled with the current accounting standard either). I tend to agree with that consensus. My first encounter with accounting standards came in 1995, when, as a reporter at American Banker, I traveled up to lovely Norwalk, Conn., to hear bank executives tell the members of the Financial Accounting Standards Board why a proposed derivatives accounting standard (what became FAS 133) was all wet. The main thing I remember was one of the bank guys complaining that the new rules wouldn't reflect the "intended economics" of a particular transaction. I didn't know much about accounting, but I knew there was something wrong with that. Investors don't need to know the "intended economics" of what a bank is up to, they need to know the actual economics of it.

I talked yesterday to my long-time accounting tutor Paul Miller, a professor at the University of Colorado at Colorado Springs who is one of our nation's most outspoken advocates of fair-value accounting (not to mention an expert in "professional golf management"), and he likened Schwarzman's argument to his own approach to updating his portfolio in his personal-finance software:

If the market's up, I update it that day. If the market's down, I don't look at it. It's the same aberrant psychological behavior.

But it also may be the right thing for Miller to do. There's an awful lot of noise and irrationality in day-to-day financial-market prices. Nassim Taleb goes on and convincingly on in Fooled By Randomness about how you'll be happier and make better investment decisions if you don't check the value of your holdings every day.

The difference, of course, is that Schwarzman is basically advocating making it impossible for Miller to update his portfolio when the market has had a really bad day. It seems like the better approach is for banks to report fair-market values, but try to educate investors about the unreliability of those day-to-day values (and structure their incentive compensation to reflect that). It's just that, when those fair-market values are rising, nobody at the banks is interested in educating anybody about their unreliability. But you certainly don't solve that by agreeing to lie about the value of your portfolio when times are bad.

Things aren't quite so clear, though, when it comes to banking regulation. Wrote fixed-income smart guy Avinash Persaud a couple months back:

I consider the primary objective of intervening in the banking market to be mitigating the substantial systemic consequences of market failure in banking. It is therefore puzzling to me that market prices are now placed at the heart of modern financial regulation, whether in the form of mark-to-market accounting or the market price of risk in risk models. It is not clear to me how we can rely on market prices to protect us from a failure of market prices.