“It’s better to have you suspect I’m broke than to have you know I’m broke.”

That's a principle suspected to be influencing financial institution accounting. For example, in the 3rd quarter, large US financial institutions reclassified $610 billion of assets into an accounting category that gives them maximum "flexibility" in assessing values, and that has increased concerns about hidden dangers on balance sheets, according to this Financial Times piece. Specifically, mortgage backed securities and collateralized debt obligations were moved from Level 2 to Level 3.

So-called "fair value" or "mark-to-market" accounting requires a 3-tier approach to placing current values on assets and liabilities. "Level 1" assets are widely traded securities with readily visible market prices. "Level 2" assets are those that lack such price data but have characteristics similar to other instruments ("proxies") for which there are observable price data. "Level 3" assets are not only hard to sell but hard to value because they lack any of those price data and have to be valued using "models." A useful discussion of these issues in an SEC-hosted roundtable in July is reported here. Speakers commented on how different companies have vastly different proportions of Level 1, Level 2, and Level 3 assets, how difficult it is to value companies by predicting earnings that are strongly influenced by revaluations, and whether fair value accounting does or does not result in more useful disclosures about financial condition.

One complaint about fair value accounting is that it makes earnings too volatile when investors want stability. One roundtable participant countered that the prices for these instruments are volatile and the financial statements should reflect that reality. That leads me back to the FT piece, where a financial industry insider is quoted saying, "A lot of banks are saying: 'I am going to move securities to level-three assets because I have more control over, and confidence in, the model used for their valuations'." In other words, securities that in the second quarter were valued by reference to observable proxy prices are now valued by non-standard models controlled by the reporting companies. The suspicion is that the reclassifications are being made in order to report higher and less volatile valuations—not because proxy price data are no longer available but because proxy price data are unwelcome. Nevertheless, the FT piece speculates that the next step after reclassification to Level 3 is further write-downs.

I previously commented on the controversy about whether fair value accounting rules should be suspended and, if so, what should take their place.