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Stress tests may shed light on Wall Street's 'mark-to-make-believe' accounting

March 5, 2012: 11:27 AM ET

Banks are still using the just trust us method to value hundreds of billions of dollars of assets left over from the financial crisis.

FORTUNE -- The stress tests, which are expected to be released by the Federal Reserve next week, will likely show that banks are better prepared for a financial crisis than they were three years ago. The tests are also likely to show the banks haven't abandoned the investments or practices that got them into trouble the last time around. Banks still have a stockpile of assets they say they have no way of valuing other than to make the numbers up.

Banks got into hot-water for putting their own price tags, rather than the market's, on their most complicated, and at the time troubled, investments during the credit crunch. Analysts questioned whether the banks were being straight with investors. It was one of the reasons banks stocks plunged in late 2008. Some called the practice "mark-to-make-believe" accounting.

These days bank stocks are soaring again. But that doesn't mean the banks have stopped playing make believe. As of the end of 2011, the nation's six largest banks label as much as $364 billion of their assets as hard-to-value. That means the banks are using their own models when determining the price they tell investors those assets are worth, not the market. That's down from the height of the financial crisis, but at some banks the level of assets they still say they can't readily value is raising eyebrows. In a recent report, bank analyst David Hendler for bond research firm CreditSights said the fact that Goldman Sachs (GS) holdings of hard-to-value assets have hovered around $50 billion for the last couple of years was a concern. The banks released new information about their assets in their annual reports last week.

At all the banks, the hard-to-value assets include auction rate securities, credit default swaps, collateralized debt obligations and other financial derivatives that created a headache for the banks during the credit crunch. But they also include some loans and more mundane assets such as mortgage servicing rights.

Banks in general are supposed to use market prices when they tell investors how much the vast majority of the bonds and stocks and other financial assets they own are worth. That's called mark-to-market accounting. But when market prices aren't available or reliable, banks are allowed to use internal models or their own judgment to determine how much a security is worth.

At height of the credit crunch, when prices of the banks' riskiest assets plunged in value, and had few buyers, the practice seemed somewhat defensible. Recently, though, the markets appear to have recovered. The Dow Jones industrial average crossed 13,000 for the first time since the financial crisis last week. Even subprime mortgage bonds appear to be gaining investors' interest again. Last week, the Federal Reserve unloaded the last of the mortgage bonds that it took off the hands of AIG during the financial crisis for a total profit of $2.8 billion.

As a result, it seems surprising that banks still have hundreds of billions of dollars of assets that they say they can't find prices for. All told, the hard-to-value assets represent an average of 4% of the assets a the nation's six largest banks. That's down from 7% at the height of the financial crisis, when those assets totaled nearly $600 billion. But the drop in hard-to-value assets has been bigger at some banks than at others.

For example, at Goldman, the value of assets that it owns and says it can't find prices in the market for rose by nearly $3 billion in 2011 to just under $48 billion. That represented 5% of the firm's overall assets. That was down slightly from nearly $55 billion in early 2009. Of its current hard-to-price holdings, about $3.3 billion were residential mortgage bonds, of which nearly $600 million were collateralized debt obligations. Just over $12 billion of Goldman's self-priced investments were in private equity funds.

JPMorgan Chase (JPM) says it can't find market prices for assets that it says are worth $118 billion, down 19% from early 2009. That represented just over 5% of the firm's overall assets, down from 7% in early 2009. Among JPMorgan's  holdings are $7.7 billion in credit default swaps. Wells Fargo's (WFC) hard-to -value assets have fallen a modest 13% as well to a recent $53 billion. Among the big banks, Bank of America (BAC) has been the most aggressive in lowering its so-called Level 3 assets, which recently stood at $51.6 billion, or just 2.5% of its overall assets, down from nearly $127 billion in early 2009.

Nonetheless, analysts in general seem less worried about these assets than they used to. Dick Bove says he listens to the earnings conference calls of 25 banks and hasn't heard a question about Level 3 assets in at least six months. Following the financial crisis it was a regular topic. Bove says there is a silver lining to the fact that the firms haven't been able to unload the assets. He believes now that the market is coming back for subprime mortgages and other risky bonds, the banks hard-to-value assets, could end up being an asset. "All of a sudden what was once the Blackhole of Calcutta could really add to the earnings of the firm,' says Bove. And you can be sure that the banks' models won't miss the way up.

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About This Author
Stephen Gandel
Stephen Gandel

Stephen Gandel has covered Wall Street and investing for over 15 years. He joins Fortune from sister publication TIME, where he was a senior business writer and lead blogger for The Curious Capitalist. He has also held positions at Money and Crain's New York Business. Stephen is a four-time winner of the Henry R. Luce Award. His work has also been recognized by the National Association of Real Estate Editors, the New York State Society of CPA and the Association of Area Business Publications. He is a graduate of Washington University, and lives in Brooklyn with his wife and two children.

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