Debugging Wall Street's funky math

NEW YORK (Wall Street) -- In the first half of the year, most Wall Street firms awarded themselves large profits from assets that are rarely traded and difficult to price, according to numbers contained in the brokerages' recent financial statements.

But, with markets seizing up since the end of June, those assets could be even harder to value, potentially prompting investors and regulators to question Wall Street's earnings.

Wall Street brokerages rely heavily on illiquid assets that are difficult for outsiders to value.

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Morgan Stanley (Charts, Fortune 500) andGoldman Sachs (Charts, Fortune 500) are scheduled to report their third quarter earnings over the next two weeks. At each firm, gains from assets and liabilities that rely heavily on subjective, in-house valuations were equivalent to 20% or more of pretax earnings, according to figures from documents filed with the Securities and Exchange Commission.

In its first half, Bear Stearns (Charts), which also reports earnings next week, appears to show losses of nearly $1 billion on these assets and liabilities, which are given the classification "level three" in financial statements, under an accounting regulation introduced at the end of last year by the Financial Accounting Standards Board. Lehman's level three gains were around 12% of pretax earnings in the first half.

Merrill Lynch (Charts, Fortune 500), Citigroup (Charts, Fortune 500) and JP Morgan Chase, which are scheduled to report third quarter earnings in October, made substantial earnings from level three assets and liabilities in the year's first half.

Brokerage houses do not break out net level three gains as a single number, so the level three figures are calculated using data contained in the banks' financial statements filed with the Securities and Exchange Commission (SEC).

Level three assets - which often include some types of mortgage-backed securities, as well as private equity investments - are the least liquid, but level two assets, which make up by far the majority of brokerage's financial assets, are also valued using arbitrary inputs because they don't trade in highly liquid markets. Only level one assets trade with dependable market prices, and they make up no more than a fourth of financial assets at most Wall Street firms.

This reliance on illiquid assets will only stoke fears that, during the credit boom of the last five years, the brokerages became too exposed to complex securities and financial instruments that will be worth less, and trade even more infrequently, in a more sober market environment. Referring to financial firms, Warren Buffett told Fortune last month, "They are marking to model rather than marking to market. The recent meltdown in much of the debt market, moreover, has transformed this process into marking to myth."

It is also likely that the Securities and Exchange Commission and banking regulators are paying close attention to valuation of level three and level two assets at Wall Street firms. Their efforts to bring liquidity back to markets relies on the resumption of sound pricing in the markets and that will take longer if banks persist in overvaluing assets using their own potentially erroneous assumptions.

Most brokerages mentioned in this story declined to comment. When asked if Goldman was overly reliant on hard-to-value assets, spokesman Lucas van Praag said: "We don't agree. Our economic exposure to level 3 assets was $24.6 billion at the end of the second quarter and that needs to be seen in the context of a balance sheet of around $1 trillion."

Morgan Stanley spokesman Mark Lake noted that a large proportion of the firm's level three gains were from real estate, an asset that has real value, even though it doesn't carry regularly quoted prices.

In addition, some on Wall Street argue that the models used to value level 2 and 3 assets are more likely to be accurate than not, because Wall Street has learned from past meltdowns that it is a big mistake to misprice illiquid assets. In addition, Wall Street's supporters say it's misleading to compare gains from level three assets and liabilities with pretax earnings. Instead, they argue that a better approach is to compare them with revenues, because the level three gains aren't reduced by accompanying expenses that do get included in the pretax earnings calculation. However, if brokerages had been tweaking internal models to produce gains, the expense associated with that would not be high and a large proportion of the resulting profits would go straight to the bottom line.

In their SEC-registered disclosures, the brokerages acknowledge that caution must be used when handling level 3 gains and losses -- and argue that the level 3 assets and liabilities may be hedged with instruments that are classed level 1 or 2. For example, Lehman Brothers' quarterly earnings statement says: "Actual net revenues associated with Level III, inclusive of hedging activities, could differ materially."

In the first half, Morgan Stanley and Goldman Sachs showed level three net gains that were the highest in their peer group, as a percentage of pretax earnings. Morgan Stanley's $2.16 billion of estimated net gains was 28% of pretax earnings, while Goldman's estimated $1.95 billion amounted to 24% of pretax earnings in the first half.

Bear's apparent $1 billion losses from level 3 assets and liabilities raise two questions. First, do the losses suggest Bear is a sort of canary in a coalmine and is just earlier than its peers in showing level 3 losses? Or was Bear uniquely over-exposed to illiquid assets that turned toxic? Third quarter results from its rivals should help answer those questions.

To be sure, these numbers do not make an open-and-shut case that a sizable chunk of Wall Street's profits are made up out of thin air. Some of the big level three gains could be on assets that are real and are actually increasing in value at the moment. For example, mortgage servicing rights, which represent future cash payments by mortgage holders to their servicers, will be worth more at a time when borrowers are doing much less mortgage prepayments -- like now.

However, few would deny that Wall Street held too many assets that are now extremely illiquid and are worth much less than they were even six months ago. Many of these assets never traded in active markets, so even honest models will be struggling to come up with dependable values. There remains a cloud over the brokerage industry so long as it continues to rely on opaque models rather than real money.