CHICAGO PROFESSOR: SOMETIMES ALL FAIR-VALUE ACCOUNTING DOES IS GENERATE USELESS MARKET NOISE. CORRECT!

On Bloomberg, Haresh Sapra from the University of Chicago explains why the transparency afforded by fair-value accounting isn’t nearly what it’s cracked up to be-especially if the “fair value” of a given asset is determined on markets that aren’t especially liquid:

[I]n relying on market prices, there is the possibility of the emergence of a feedback loop in which the anticipation of short-term price movements may induce insiders of financial institutions to respond in ways that amplify these price movements.

The more sensitive financial institutions are to short-term price changes — perhaps because of illiquid and incomplete markets — the stronger the feedback effect. When such effects are strong, the decisions of financial institutions are more likely to be based on second-guessing of their competitors than on perceived fundamentals. Thus, the accounting norm itself may become the source of additional, internally produced volatility, as opposed to volatility that reflects the underlying fundamentals.

Ring any bells? In case not, Sapra provides an example of what he’s talking about, from the credit crunch. As liquidity dried up, banks scrambled to sell their illiquid loans, which drove down prices. Other banks, anticipating the price drop, scrambled to sell their loans, as well, to avoid ruinous marks. Presto! Feedback loop underway. Loan prices cratered–but the decline occurred entirely because the banks were reacting to accounting rules, and had little to do with any changes in credit quality of the loans themselves. People freaked out anyway. Result: an accounting rule that was designed to increase transparency actually reduced it-to disastrous results. . . .