Don’t Look Now… But Mark-to-Make-Believe is On the Rise

Here's a little credit-crunch update for your consideration over the weekend...

Last year as the credit crunch market shock was just getting started, I wrote about accounting rule changes that signaled more trouble ahead for Wall Street’s big banks and brokers.

These troubles are now ballooning in value on the balance sheets of these firms. Watch out!

Here’s a quick refresher course on changes in the ground rules for this accounting shell-game. Last November a new accounting regulation from the Financial Accounting Standards Board took effect (FAS 157) that changes the way firms account for balance sheet assets. This new rule forces companies to “mark-to-market” their assets at the end of each quarter.

But it also allows firms to divide these assets into one of three categories. This change has had perhaps the biggest impact in the financial sector. Here’s how it works:

Level 1 assets have easily “observable market prices. Think of a company like Berkshire Hathaway (BRKA) for instance, which owns lots of Coca-Cola (KO) shares. That’s easy to value, just look up the quote on the NYSE. These assets have legitimate values.

Level 2 assets don’t have an easily “observable” price. These might be credit-default swaps or other derivatives, where you can have to “guess-timate” the value based on other market data such as Treasury yields. This is “mark-to-maybe” accounting; as in, maybe the value is right, and then again maybe it’s not.

Level 3 assets are the most opaque – if not totally fantasized. Here there are NO “observable prices”. Think of say, sub-prime mortgage backed securities, or leveraged loan securities – that don’t trade at all in this credit-challenged market.

Since there’s no market price available, the firm’s management and its bean counters have lots of leeway in making an “estimate”. This is what I call “mark-to-make-believe” accounting!

As in: I believe this Level 3 asset is worth a billion dollars today; maybe it’s only worth half-that (or even less), but let’s say it’s $1 billion this quarter and call it a day…

First Quarter Disclosures Show Soaring L-3 Assets on Wall Street

Now, if you fast-forward to the present, and look at some of the recent first-quarter financial statements from leading banks and brokers, guess what you’ll find?

Yep, Level 3 Assets are expanding fast! In spite of more than $320 billion in collective losses and asset write-offs (and still counting) taken by global financial firms so far, there’s still far too much mark-to-make-believe going on down on Wall Street.

Merrill Lynch (MER) has already written off nearly $32 billion in assets since the credit crunch began. But in the first quarter of 2008, Merrill’s hard to value Level 3 assets soared 70% to $82 billion, up from $48 billion in December.

Citigroup (C) has reported credit write-offs and losses of more than $40 billion so far. That didn’t stop Citi from reporting its Level 3 assets still climbed 20% last quarter to $160 billion!

Morgan Stanley’s (MS) illiquid assets jumped to $78 billion at the end of March. That's in addition to the $12.6 billion the firm has already written-off. At Goldman Sachs (GS), assets classified as Level-3 surged 39% to $96 billion last quarter.

How much, if any, of these illiquid asset values will ever be realized in cold hard cash is the multi-billion dollar question. Investors are right to be afraid (very afraid) of the day when Wall Street’s finest can no longer get away with this fantasyland asset pricing, and are forced to admit the ugly truth, there could be hundreds of billions more in losses.

That particular market shock is still lurking out there, cleverly hidden for the moment by Wall Street’s shell-game accounting rules. Stay tuned.