02 June 2012

In Defense of Gambling with Borrowed Chips, Part II

My recommendations, in Gambling with Borrowed Chips, are as follows:

1)      That  the U.S. government must repeal its legal tender laws, allowing Americans to find our own money.

2)      That there ought to be a simple and complete abolition of the Federal Reserve System

3)      That we must learn to let failures fail, without Greenspan or Bernanke “puts” and, finally,

4)      That “we need as a people to accept an important cultural change – we need to learn greater respect for the profession of accounting and for its independence.”

That’s the list as I presented it in my conclusion and as Gravelle considers it. In this blog, I propose to reverse the order. Starting with number 4 then, my reviewer plainly thinks this the runt of the litter. She isn’t “sure what Faille specifically proposes” in this line, so she won’t comment on it.

Well, perhaps in the PowerPoint sense I don’t “specifically propose” anything. It is hard to reduce a critical cultural shift to a list of specific proposals. It isn’t a matter for departmental white papers.  It is a matter of focus.

But I’ll dwell on this point today because recent newspaper accounts of JPMorgan and its billions of dollars lost on portfolio hedges tell a story that may assist with the needed cultural shift if anything can. These losses have stiffened the resolve of advocates of the “Volcker rule,” and of a stern construal thereof, and have at the same time confused those who have been trying to rejigger that rule to allow some flexibility, so this incident may end up having a lot to do with the future of investment banking in the US.  

JPM’s CEO, James Dimon, has said that "affiliated but asymmetric accounting" may have contributed.

Does this bore you, dear reader?  Are you saying, “oh, no, a discussion of accounting.” I suggest you resist the impulse to say that. That is all I “specifically propose” in such matters.

The problem in this case may have been that (a) derivatives on credit default swaps are marked to market – their value is constantly re-adjusted under existing accounting principles, but (b) the value of a bank’s outstanding loans are not marked to market – they are carried at original value, and adverse market condition are acknowledged through the creation of a reserve. If derivatives are used to hedge risks inherent in the loan portfolio then, as the “Heard on the Street” column in the Wall Street Journal has recently noted, the derivative can distort apparent earnings, and distort the bank’s own managerial processes.

I would certainly hope that bankers will correct this asymmetry by marking loans to market, and that the professional (private sector) bodies that maintain accounting standards will press toward this end. Prospects for that are not good at the moment, for reasons that were foreshadowed by the discussion in chapter eight of my book.  The leaders of the standards-setting bodies have been spineless and various politicians have introduced demagogy into accountancy issues over the years, cowing the spineless into indecision when the bases for sensible decisions were fairly clear.

If the politicians were to stand back, the accounting profession would hash out its own issues. And if the public were informed, if there was a general cultural acceptance of the importance of independent integral accounting standards, the leaders of that profession might exhibit the necessary backbone. Then we wouldn’t need a Volcker rule to do their work for them.


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