Accounting rules and the financial meltdown

Today's WSJ had an interesting, albeit not very clearly written, op-ed by Zachary Karabell blaming post-Enron accounting rules for helping create the AIG meltdown. Read in conjunction with the WSJ's front-page coverage of the AIG drama as a case study in "deleveraging," the story appears to be as follows. As we all know, financial institutions (like all other companies) dislike having to write down their assets on the books and have long resisted doing so even when value has declined. For a long time, they could. But post-Enron, the accounting rules were changed to require more write-downs to market value. This, in turn, then triggered a self-reinforcing cycle of write-downs triggering mandatory asset sales, triggering distress prices far below fundamental value, triggering more write-downs, triggering more mandatory asset sales, and so forth. (Apparently a story that Bernanke, among others, has endorsed.)

One part of the story is that whoever buys the assets at distress prices far below fundamental value ends up doing just great when the dust settles. In the more rational world of an economics textbook or model, all you need is two such prospective purchasers who are competing with each other, rather than colluding, to drive the price up to fundamental value and make this scenario impossible. But apparently there isn't enough liquidity and prospective demand for under-valued assets for this to happen, especially when the bowling pins start falling one after the other.

As an aside, this I gather was at play in the collapse of Long-Term Capital Management some years back. A credit crunch forced them to sell assets for way below fundamental value, leaving some very happy purchasers to clean up (but apparently there were too few of them to drive the prices back up, and perhaps there was even implicit collusion to all enjoy part of the good thing that was popping into their laps).

Anyway, all this can't and won't happen in textbook financial markets, but I gather it actually is happening out there in the world, even at this very moment. One of the issues it raises is what to do with the accounting rules, which play a triggering role in the self-reinforcing downturn.

Obviously we want financial accounting to report true value. The argument here is that true value is hard to identify when you have a temporarily low market value and a higher fundamental value, and when the market mechanisms (arbitrage, etc.) that are supposed to drive these together aren't currently operating.

Is the solution not to write down assets to market valuation when there's reason to think that fundamental value is actually higher? This might sound good to me if we had Olympian companies and accountants honestly and objectively trying to determine when the two have been temporarily driven apart. However, given managerial incentive problems, along perhaps with evidence that they try to ignore, rather than just publicly deny, downturns in the making, it doesn't sound very good either.

So let's call it an open question for now what if anything should be done from an accounting standpoint about the deleveraging scenario that is currently hitting the markets so hard.