Reply #18: Quelle Surprise! Banks Increase "Mark to Make-Believe" Assets to $610 Billion

[ozymandius]

Banks are, if nothing else, entirely predictable. If there is a way to game the system, they will avail themselves of it.

Readers may recall that the Financial Standards Accounting Board implemented Statement 157, which required financial firms to identify how they arrived at the "fair value" for their assets. Level 1 are ones where there is a market price. Level 2 are those where there may not be much of a market, but they can nevertheless be priced in reference to similar assets that have a market price.

Then we have Level 3. They are priced using "unobservable inputs." I have never understood this concept, because the use of sunspots, skirt lengths, the Mayan calendar, or a model using, say, a ratio of bullish versus bearish stories on Bloomberg would be an observable input. And fittingly, Level 3 is colloquially called "mark to make believe."

And there are indeed signs that indicate that financial firms have playes fast and loose with this rule:

1. In the first quarter of 2007, Wells Fargo created $1.21 billion of Level 3 gains. Without them, it would have posted a loss.

2. Lehman added more assets to the Level 3 category at a time when better trading conditions said it should have been lowering them

However, it is now completely kosher to play games. While the three-level hierarchy became effective on January 1 of this year (some firms chose to comply early), the SEC largely gutted it in the wake of the Bear collapse. From its March press release:

Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale (boldface ours).

Fast forward to today. What do we see now? The financial services industry has a world-class bad quarter. So what does it do? increase the amount of assets it considers to be Level 3 so it can assign them more favorable prices.

And there is possibly a second reason for this move. Year end financials are audited. Accountants have been much less accommodating of late. Moving a lot of assets into the Level 3 bucket right before your auditor walks in might not pass the smell test (although once you have done that, they really cannot question how they are marked). Better to do it at least a quarter in advance.

http://www.nakedcapitalism.com/2008/12/quelle-surprise-banks-increase-mark-to.html