Banks are doing everything they can to avoid telling investors just how little the crap on their balance sheets is worth. The longer they can maintain this fiction, the longer they can wait before taking the inevitable write-offs (which would create the need for still-more capital).
Bank accounting rules allow banks to put assets into three buckets:
- Level 1: For liquid assets with readily observable market prices
- Level 2: For less liquid assets for which recent market comparables are available
- Level 3: For all the stuff that banks want to argue is worth more than it really is
Banks determine the value of “Level 3” assets by performing their own valuation analyses–which is to say, they decide what they want the assets to be worth and then develop assumptions that justify this value. The only requirement for these assumptions is that a snooping accounting not pass out in shock.
Because justifying fictional values of Level 1 and Level 2 assets is harder to do, banks have responded by moving more assets into the Level 3 category.
Financial Times: The biggest US financial institutions reported a sharp increase to $610bn in so-called hard-to-value assets during the third quarter, raising concerns about the hidden dangers on balance sheets.
So-called level-three assets, classified as hard to value and hard to sell, rose 15.5 per cent from the second quarter, according to analysis by the Market, Credit and Risk Strategies group of Standard & Poor’s.
Yves Smith at Naked Capitalism has more on this:
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”…
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 favourable 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…