The nightmare on Wall Street continues: This just in… Bloomberg reported yesterday that big U.S. banks and brokerage firms may be forced to write-off as much as $100 billion in additional sub-prime related losses, due to pending accounting rule changes that take effect November 15.
This is in addition to the roughly $40 billion in losses and asset write-offs that Wall Street has already been taken over the past few months, due to the sub-prime credit slump.
This morning, Wachovia joined a growing chorus of Wall Street banks that are announcing even more sub-prime related losses on their balance sheet. Wachovia said the value of sub-prime related debt fell about $1.1 billion in October alone. The Wall Street water-torture continues with new revelations nearly every day.
Recent rule changes by the Financial Accounting Standards Board make it more difficult for companies to avoid putting real-world market prices on their hardest-to-value securities, known as Level 3 assets.
As Easy as Level 1, 2, 3…
Level 1 assets are easy to price using mark-to-market accounting, you have all probably heard that term. This is where an asset's worth is based on a real price. For instance IBM… check the quote on the NYSE – that’s the “mark to market” price.
Level 2 assets use something called “mark-to- model”, but I call it Mark-to-Maybe. This is an estimate based on “observable inputs” which is used when no actually price quotes are available. An example might be a private transaction between two banks. They’re saying “Maybe” this is what its worth.
Then there’s Level 3 asset values, which are based on “unobservable” prices. This is basically the banks’ own “assumption” as to what the assets are worth. This is what’s been called “Mark-to-Make-Believe” accounting. Because it’s all just Fantasyland pricing… pure guesswork on the part of these Wall Street firms who of course are looking to cover their butts with the most generous valuation they can dream up.
Is the Financial Day of Reckoning Close at Hand?
However the day of reckoning may arrive in six more days, when the new and more stringent FASB accounting rules take affect. The $40 billion in charges taken so far are just the tip of the iceberg compared to what we may soon see.
According to analysis by the Royal Bank of Scotland, this “credit crunch may result in $250 billion to $500 billion of losses,” once all is said and done, as more banks and brokers are forced to revalue a decent portion of these “mark-to-make believe” assets.
Real world indexes that investors use to track deteriorating sub-prime bonds are showing “observable levels” (Level 2 pricing) that would wipe out ALL of the capital of several major Wall Street firms if the index prices were used to value their Level 3 assets.
Wall Street's Equity Wipe-Out
According to RBS, Morgan Stanley still carries Level 3 assets on its books equal to 251% of its total equity, “making it the most vulnerable to writedowns.” This means that if the house of Morgan writes-off just half its Level 3 assets – its entire equity capital would be wiped out!
Following close behind in terms of risk is Goldman Sachs at 185%, while Lehman Brothers has the equivalent of 159% of equity in Level 3 assets, and Bear Stearns with 154%. Citigroup, even after its announced $11 billion write-down, still has Level 3 assets worth about 105% of equity.
Stay tuned, next week could get really interesting.
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