Marked to Myth, Still

I have seen this in proprietary research that I cannot quote. But the missive below is in the public domain and would give you a good idea what it means to make up earnings and hide loses. Make no mistake, the losses will be realized. But they will be amazingly large, threatening wipeouts of big Wall Street firms.

Caldwell & Orkin (PDF):

In July 2007, we were told by the banks and brokers that the poor investments they made in subprime mortgages, CDOs and CLOs would not harm their balance sheets and would lead to, at most, minimal charges recognized in the second quarter (see September 2007 Update). Then we learned that the banks and brokers were valuing these securities at 97 cents on the dollar, even while the bonds held by these securities had lost more than half their value. These charges were justified via internal valuation models that clearly had no basis in reality. The sum of the parts did not equal the whole.

When valuing hard-to-trade securities, institutional investors are allowed to classify assets as Level 1, 2, or 3. Level 1 asset values are the most transparent, as they are frequently traded and have readily available pricing. Level 2 assets are less frequently traded, but are marked to market-listed prices. Level 3 asset values are the least transparent as they seldom trade and are, therefore, dependent upon subjective inputs determined by the asset holder, or what Warren Buffett calls “marked to myth.” According to Portales Partners, three of the top five brokerage firms increased their Level 3 “marked to myth” asset classifications by over 30% during the third quarter of 2007. “Everyone has an incentive in the short run to put the best face” on valuations, says Peter J.  Solomon, a former Lehman Brothers vice chairman. “Their compensation is totally based on it. In securities that don’t have ready markets, particularly when the markets are troubled, it makes one totally suspicious.”5  Executives at UBS AG fired hedge fund manager John Niblo for his refusal to play along with this “mark to myth” game. According to The Wall Street Journal, Niblo was fired after marking some of the mortgage-backed securities in his fund in the range of 50 to 80 cents on the dollar. The problem: UBS held similar securities in other accounts that they had valued in the range of 80-89 cents on the dollar. Mr. Niblo is alleged to have asked his bosses at UBS how they could value the securities at a higher level “if [they] can’t sell them at these prices?”6 “Good question,” his bosses probably responded. “Now go find another job.”

J.P. Morgan Chase & Co. analyst Kedran Panageas estimates that 29% of lower-quality CDOs  and 12% of higher-quality CDOs will eventually lose all of their value. Overall, she estimates the lost value is roughly $85 billion of the $475 billion of such securities outstanding, with investors having only recognized a fraction of those losses. Even with the additional write-downs that accompanied the firing of a few brokerage firm CEOs in late October 2007, we are yet to see realistic, market-based charges taken against subprime mortgage, CDO and CLO holdings. [emphasis added]

If losses are too big, put them in the footnotes. And fire that whistleblower.

 www.markit.com

I would be the first to tell you that Citigroup – the biggest US bank and a great example of the current situation – is overextended to the downside. But, if one cannot trust the earnings, book value, etc. for the above mentioned reasons, who's to say how low is too low?

 www.stockcharts.com