Level 3 Profits. Hooray for creative accounting!

Courtesy of Bloomberg and Johnathan Weil:

April 23 (Bloomberg) -- Here's Rule No. 1 from Wall Street's public-relations
playbook: If the company you run has big losses on hard-to-value assets, scream
your head off about the accounting rules.
And what if the squishy values
result in huge gains instead, as they have in the not-so-distant past? Rule No.
2: Stay mum about it for as long as the rules allow.

There you have it folks. A cliff notes version of how to run a Wall Street firm, when you make bad decsions complain about the accounting rules that force you to admit your mistakes. Then make sure you take all that crap sitting on your balance sheet that has no market and claim that you profited immensely from it:

There has been no commensurate outrage about fuzzy mark-to- market
accounting that lets companies post unrealized gains on illiquid balance-sheet
items. Yet if it weren't for large non- cash profits on hard-to-value holdings, Goldman Sachs Group
Inc. wouldn't have had much profit last quarter. Lehman Brothers Holdings
Inc. would have had significantly less. And Morgan Stanley wouldn't
have had any.
You wouldn't have known those things from the earnings press
releases the three investment banks issued in mid-March. Investors had to wait
until a few weeks later to find out. That's when the banks filed their quarterly
financial statements, including footnotes showing changes in their so-called
Level 3 assets and liabilities.
The rules allow such delays. What's amazing
is that the banks' investors aren't demanding to get this information sooner.

So lets try and get everyone to understand the hierarchy of Level 1, 2, and 3 assets.

1. Level 1: Mark-To-Market Go look up any stock, bond, option, mutual fund on your investment brokerage account. Very easy to value and all gains and losses are reported each quarter on your earnings.
2. Level 2: Mark-To-Model Prices don't exist, so you create a computer program to create a synthenic value for your illiquid product based on price inputs observable in a liquid market.
3. Level 3: Mark-To-Make Believe Essentially a level 2 asset however one of your inputs doesn't have an observable liquid market so you make your own assumptions about its pricing, essentially imagining a market for this input.

Weil Continues:

There isn't anything necessarily wrong with Level 3 measurements. By
definition, though, they are less certain and more prone to bias. There's
nothing new about Level 3 gains and losses either. They just weren't called
Level 3 before FAS 157, which the major investment banks adopted last year, and
didn't have to be disclosed.
Break Down
Here's how the numbers break
down. For the quarter ended Feb. 29, Morgan Stanley reported $4.24 billion of
net unrealized gains on Level 3 assets and liabilities. That was almost twice
the company's $2.21 billion of pretax income.
Those figures included $8.39
billion of net gains on Level 3 derivative contracts, driven in large part by
adjustments on credit-default swaps, which Morgan Stanley used to buy protection
against declines in the creditworthiness of various holdings.
Morgan Stanley
included the $8.39 billion on its income statement as part of trading revenue,
which was $3.39 billion last quarter. So, without those items, Morgan Stanley's
trading revenue would have been negative $5 billion. (Yes, negative.)
At
Goldman, net unrealized Level 3 gains were $2.07 billion for the quarter ended
Feb. 29, equivalent to 96 percent of the company's $2.14 billion of pretax
income.

Please read the rest of his piece here:
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a0ZGtAQHLpiA