This shouldn’t come as a surprise…

Banks Hide $35 Billion in Writedowns From Income, Filings Show: “Banks and securities firms, reeling from record losses resulting from the collapse of the mortgage securities market, are failing to acknowledge in their income statements at least $35 billion of additional writedowns included in their balance sheets, regulatory filings show.

Citigroup Inc. subtracted $2 billion from equity for the declining value of home-loan bonds in its quarterly report to the Securities and Exchange Commission on May 2 without mentioning the deduction in the earnings statement or conference call with investors that followed. ING Groep NV placed 3.6 billion euros ($5.6 billion) of negative valuations in its capital account, while disclosing only an 80 million-euro depletion to income.

The balance-sheet adjustments are in addition to $344 billion of writedowns and credit losses already reported on the income statements of more than 100 banks. These companies have raised $263 billion from sovereign wealth funds, their own governments and public investors to shore up capital. The balance-sheet writedowns also reduce equity, which needs to be replenished. Adding the $35 billion leaves the banks with a $116 billion mountain of losses to climb.”

It’s those damn account rules.

“Taking losses on a balance sheet instead of an income statement is acceptable under accounting rules, which make a distinction between so-called trading books and long-term investments. Changes in value on the trading side go straight to revenue. Changes in the value of bonds held for the long haul can be marked down on the equity line of a balance sheet, as long as the declines aren't considered permanent.

Banks that are more willing to acknowledge their balance- sheet writedowns, such as Amsterdam-based ING, say the valuations of assets will be reversed when markets recover. ING, the biggest Dutch financial-services company, said in its first-quarter earnings report last week that the drop in the value of bonds tied to home loans that are held to maturity is irrelevant as long as the underlying mortgages don't default.

With that logic, most of the writedowns on the income statements could be reversed if asset prices recover. While some declines in valuations may reverse, most of the losses are permanent impairments caused by surging defaults on U.S. mortgages, said Janet Tavakoli, author of ``Collateralized Debt Obligations & Structured Finance,'' published in 2004 by John Wiley & Sons Inc.”

Worse still, the writedowns are overly conservative. The best evidence of just how inadequate these writedowns really are can be found in the continued explosion of Level 2 and Level 3 asset values. These values are growing rapidly and in many cases now the entire fate of a company rests on these arbitrary values.

For example, just recently Freddie Mac (FRE) moved $156.7 billion, or 23% of its assets, to Level 3. In so doing, FRE was able to report losses of “just” $151 million. By moving $156.7 billion into the Level 3 asset bucket, FRE now has the ability to come up with its own valuation. This was all perfectly acceptable under FAS 157. Despite these desperate measures FRE reported that the “fair value,” or estimated market value of its net assets, was a negative $5.2 billion as of March 31. I can’t imagine that FRE is valuing its Level 3 assets at anything but reckless, fantasy levels. Therefore, I have to assume that the fair value of FRE assets is actually worse than the negative $5.2 billion reported.

I think Janet Tavakoli has it just about right:

“Of course we can't tell how much of a bank's portfolio may actually be good stuff that will pay back at maturity.