If you think banks are writing off large amounts of assets now, wait until new accounting rules take effect this month.
The Royal Bank of Scotland Group estimates that U.S. banks and brokers, already under massive losses caused by the collapse in the subprime credit market, potentially face hundreds of billions of dollars in write-offs because of what are called Level 3 accounting rules, according to Bloomberg.
The U.S. Financial Accounting Standards Board Rule 157, which is effective for fiscal years that begin after November 15, 2007, will make it harder for companies to avoid putting market prices on securities considered hardest to value, known as Level 3 assets, the wire service reported.
”The heat is on and it is inevitable that more players will have to revalue at least a decent portion” of assets they currently value using ”mark-to-make believe,” Bob Janjuah, Royal Bank’s chief credit strategist, reportedly wrote in a note published Wednesday.
Janjuah noted that, for example, Morgan Stanley has the equivalent of 251 percent of its equity in Level 3 assets, Goldman Sachs has 185 percent, Lehman Brothers has 159 percent and Citigroup has 105 percent, according to Bloomberg.
On the other hand, Merrill Lynch has Level 3 assets equal to 38 percent of its equity. As a result, Janjuah believes Merrill ”may well come out of all of this in the best health.”
In the fair value hierarchy, Level 1 is simple mark-to-market, whereby an asset’s value is based on an actual price. Level 2, known as mark-to-model and used when there aren’t any quoted prices available, is an estimate based on observable inputs, Bloomberg explains.
Level 3 consists of unobservable inputs, such as those that reflect the reporting entity’s own assumptions about what market participants would use to price the asset or liability (including risk), developed using the best information available without undue cost and effort, according to FASB. There is no verification requirement if the assumptions are in line with those of market participants.
FAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair-value measurements, FASB explains.
FASB notes that until now, there have been different definitions of fair value and limited guidance for applying those definitions in GAAP. Also, that guidance was dispersed among the many accounting pronouncements that require fair-value measurements.
Differences in that guidance created inconsistencies that added to the complexity in applying GAAP. In developing FAS 157, FASB said it considered the need for increased consistency and comparability in fair-value measurements and for expanded disclosures about such measurements.