Fun with mark-to-make-believe, Morgan Stanley edition

Here we go…

If you thought the fog surrounding the value of debt securities was starting to lift, think again.

For a reality check, we would direct you to a brief but illuminating nugget that appeared in Morgan Stanley’s year-end financial results, which it filed Tuesday with regulators. Deep in the 10-K, the securities firm disclosed that during its fourth quarter, it “reclassified” about $7 billion in assets to what is known in accounting circles as “Level 3″ status. Level 3 assets are things on a balance sheet whose value on a given day is more or less a big, fat question mark — or, to put it more scientifically, whose valuation is “based on inputs that are unknowable.”

[In turn, that means that the owner of the Level 3 assets gets to value them according to a hypothetical model that the owner gets to create. Wouldn’t you like to be able to do that when, say, filing your personal tax return?]

The fourth-quarter reclassification doesn’t necessarily [yes, “necessarily” is the key word in this sentence] mean that these assets are worth less today than they were yesterday. Morgan Stanley hasn’t taken a charge because of the accounting change.

But it does mean that Morgan Stanley felt a lot less confident than it did just three months earlier about how to put a price tag on those assets. That, in turn, could imply that the debt markets are becoming more opaque instead of less — which might reasonably raise questions about the accuracy of the recent spate of multibillion-dollar write-downs at Morgan Stanley and other Wall Street firms.

In its filing, Morgan Stanley put most of the blame for the latest reclassification on “continued market and liquidity deterioration in the mortgage markets.” [I.e. none of these things we own are trading, so we have no idea what they’re worth, or how many pennies on the dollar we will eventually be able to get for them.]

Morgan Stanley said its new Level 3 assets included commercial whole loans — which is potentially disturbing in itself, because these assets are outside the residential-mortgage market when the subprime troubles began — as well as residuals from the securitization of residential mortgages.

On the bright side, the total value of Morgan Stanley’s Level 3 assets actually declined in the period between Aug. 31 and Nov. 30, regulatory filings show. For example, its debt-related Level 3 assets were $37 billion [!!!] at the end of November, down from $43.3 billion at the end of August.

[Source: New York Times Dealbook.]

Faithful readers of this blog will recall a prior post on Level 3 assets.