Banks and brokers have been scrambling like mad to raise capital in the wake of declining asset prices. In response, some top banks would prefer to pretend that problems do not not exist. For example, please consider Top banks call for relaxed writedown rules.

The world’s leading banks have stepped up pressure to relax controversial accounting rules with a new plan aimed at breaking the “downward spiral” of huge writedowns, emergency fundraisings and fire-sales of assets.

The proposals on “fair value” accounting by the Institute of International Finance (IIF), an alliance of 300-plus companies chaired by Josef Ackermann, Deutsche Bank’s chairman, would enable financial companies to cushion the blow of financial crises by valuing illiquid assets using historical, rather than market, prices.

Under the plan, which has been obtained by the Financial Times, banks that decided to keep assets on their balance sheet would also be freed from the requirement to hold them to maturity and would be able to sell them after two years.

The IIF’s proposals, which were sent to US and European central banks, governments and accounting watchdogs, underline financial groups’ view that the credit crunch will inflict long-lasting damage on their business.

The IIF’s paper says: “The writedowns required under current interpretations may be substantially in excess of any actual or reasonably probable loss on many instruments”.

“Often dramatic writedowns of sound investments required under the current implementation of fair-value accounting adversely affect market sentiment, in turn leading to further writedowns…in a downward spiral that may lead to large-scale fire sales of assets,” the IIF’s paper argues.

Goldman Sachs calls IIF Proposal “Alice-in-Wonderland Accounting”

The Financial Times is reporting Goldman set to sever IIF links.

Goldman Sachs said it was likely to sever its links with the Institute of International Finance after the association of leading banks and insurance companies called for a relaxation of controversial accounting rules on asset valuation.

Goldman, one of the IIF’s 370-plus members, said it did not agree with the IIF’s proposals, which have been circulated to regulators and politicians over the past month, and opposed any changes in “fair value” accounting.

“The proposals are extraordinary,” a Goldman official said on Thursday. “This is Alice-in-Wonderland accounting.”

He said that Goldman had a representative on the IIF’s committee responsible for the proposal but she was not directly involved in its drafting. Goldman would almost certainly leave the IIF following the report.

Under the IIF plan, revealed by the Financial Times this week, banks would be allowed to use historical, rather than market prices, to value illiquid assets – a change that could help to reduce the negative impact of the crisis on their strained balance sheets.

Historical Pricing

Here is an example of historical pricing: A house was valued at $1,000,000 two years ago. There are no bids on it today so let’s keep it on the books at $1,000,000. Here is another one: There is no bid on various subprime or Alt-A derivatives so let’s keep those on the books at historical values as well.

Level 3 Wonderland

Ironically, there is already an enormous amount of pretending going on, even at Goldman who opposes this rule change.

Inquiring minds may wish to consider Slow Motion Train Wreck, Deflation In A Fiat Regime? and The Moral Hazard Club by Professor Sedacca. Here is a snip from the latter:

When you add up all the Level II assets by just the eight largest holders in the U.S: JP Morgan (JPM), Citibank (C), Bank of America (BAC), Merrill Lynch (MER), Goldman Sachs (GS), Bear, Morgan Stanley (MS) and Lehman Brothers (LEH), it comes to a staggering $5 trillion – nearly half the size of the economy. Level III assets are nearly $600 billion.

Is the Fed big enough to bail out all these assets? My best guess is probably not, and more firms will fail. If the loans and economy both don’t start performing, these failures will happen more quickly, which is why my firm continues to avoid credit risk. It’s not hard to envision an acceleration of this process if the market starts to believe the special loan facilities and other funding processes artificially created to deal with this mess cease to work.

The Fed is slowly becoming the dumping ground for dealers and banks – members of the ‘Moral Hazard Club.’ It’s is running out of capital, and quickly.

The problem assets (at least the ones we know about) are way too large for the Fed to completely absorb. It’s waiting and hoping the economy and credit markets stabilize before it runs out of ammunition.

Citigroup (C), Goldman Sachs (GS), Morgan Stanley (MS), and JPMorgan (JPM) have staggering amounts of level three assets, no doubt kept on the books at fantasy prices. I am confident that the merger of Bank of America (BAC) and Countrywide Financial (CFC) will put Bank of America in the same spot (assuming the deal goes through but it may not). The shotgun marriage between JPMorgan and Bear Stearns (BSC) will add to the problem at JPMorgan.

For a description of what Level 1, Level 2, and level 3 mean please see Marked to Fantasy. Level 3 assets have actually been rising at many institutions. Why?

1) SIVs and other garbage that was kept off the balance sheets entirely are being brought back on the books as Level 3 assets.
2) Banks are not ready or willing to mark that garbage to market (it would be too capital impairing) so they are hiding out in “Level 3 Wonderland”.

There’s no need to change the rules when hiding out in Wonderland accomplishes the same thing.

Mike “Mish” Shedlock
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