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Marking Down Wall Street

By DAVID REILLY
September 14, 2007; Page C1

For the past three tumultuous months, investors have found it difficult, and sometimes impossible, to price many exotic financial instruments hard-hit by subprime turmoil.

Now, with some of Wall Street's biggest names -- Goldman Sachs Group Inc., Lehman Brothers Holdings Inc., Morgan Stanley and Bear Stearns Cos. -- set to begin reporting results for this period next week, investors will be paying particular attention to the impact this has had on the brokers' balance sheets.

[Investment Banks]

As they pore over the books, investors are likely to home in on data that have only recently begun appearing in the firms' financial statements. Under a new accounting rule, firms are distinguishing between financial assets that have real market prices versus those based on models and those that are little more than management guesses.

The upshot: Given current market stresses, bigger portions of the firms' securities holdings might fall into the category of management guesses, and relying on these estimates might not help restore investor confidence.

The uncertainty surrounding assets based on estimates, given current market conditions, could affect investors' view of firms' book values. That could call into question bullish arguments that the firms are undervalued at current, historically low price-to-book-value multiples.

In addition, if investors grow concerned about the true value of some of the assets on the firms' balance sheets, this could make them anxious about the amount of borrowed funds that the firms employ. Any change in sentiment on that score could force the firms to grow more conservative, leading to lower earnings.

The firms began breaking down their financial assets into these "levels" at the start of their current fiscal year, which began in December, when they early adopted a new accounting standard related to fair, or market, value measurement. All U.S. companies will have to begin using it for financial years starting after Nov. 15.

During the first two fiscal quarters, investors didn't pay that much attention to this new data, which break financial assets down into three valuation categories. Now, with pricing -- or marking -- a big concern on Wall Street, skittish investors are expected to pore over the information.

The biggest area of concern will be the category for asset values based on estimates, or Level 3. These assets made up about 10% or less of overall financial assets at Goldman, Morgan, Lehman and Bear at the end of their fiscal second quarters. Including Merrill Lynch & Co., which doesn't report results until next month, the firms designated $331 billion as Level 3 assets, or about 6% of total assets.

Of the nearly $270 billion in financial assets on Lehman's balance sheet at the end of the fiscal second quarter, for example, about $22 billion, or 8%, fell into what is called Level 3. The firm said in its financial filings that values in this category "reflect management's best estimate of what market participants would use in pricing the asset." At Bear, about $18 billion of the firm's $220 billion in financial assets fall into this category.

At both firms, the bulk of their financial assets -- $152 billion for Lehman and $163 billion for Bear fell into the mark-to-model category, or Level 2. Assets in Level 1 trade in active markets with readily available prices.

Among issues that will now concern investors: How much in unrecognized gains and losses is being generated by Level 3 assets. Too large an amount of profit from these assets could call into question the quality of a firm's earnings.

Investors also will be watching to see if Level 3 assets soar, particularly if a firm has to reclassify Level 2 assets. Earlier this year, changes in Level 3 assets were relatively small. At Lehman Brothers, for example, nonderivative, Level 3 financial assets rose to $19.6 billion in the second fiscal quarter from $16.2 billion in the first quarter.

The worry is that bigger changes could be in store given the current problems in markets. That could prove a warning signal to investors.

So far, the data provided by the investment banks in the first two fiscal quarters haven't provided evidence that they may be playing accounting games with their valuations, according to a report from Sanford C. Bernstein & Co. analyst Brad Hintz. However, the firms' didn't face the same harsh market conditions during those periods. Also, the firms could now face a greater possibility of having to write down the value of assets, which would be more likely to affect those classified as Level 3.

Overall, this could add up to more risks for a group whose outlook already is cloudy and whose stocks have taken a recent pounding. Up to yesterday, Goldman and Morgan were down about 20% since the start of the year, Lehman had dropped more than 25% and Bear had fallen more than 30%.

In New York Stock Exchange 4 p.m. composite trading, Goldman rose 3.3%, or $5.94, to $188.47, while Morgan jumped 5.3%, or $3.33, to $66.79, Lehman gained $2.60, or 4.6%, to $59.68 and Bear shares gained 4.3%, or $4.78, to $114.83.

Of course, the most immediate concern for investors will be whether the financial-markets crisis is subsiding. Lehman will be the first to report next week. Some bad news already is baked into investor expectations, given that the firm has recently closed some of its mortgage businesses and announced layoffs of about 9% of its 28,000-person work force.

Investors are cautiously optimistic about results at Morgan, which reports Wednesday, and Goldman, which reports the day after and may even provide some upside surprise, according to people familiar with the matter. But Bear, which posts results Thursday, is fueling worries because it is by far the most dependent on mortgage revenue.

--Kate Kelly contributed to this article.

Write to David Reilly at david.reilly@wsj.com

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