Unsafe at any valuation

Watching the rating cuts trickle out of the derivatives forest is akin to searching for elephant dung on a path to try and work out how many pachyderms are in the jungle. There's clearly a herd in there. And it's probably much bigger than the ordure you have seen so far would suggest.

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Here's what is most worrying about the coming flood of downgrades and defaults. The U.S. Securities and Exchange Commission is investigating how the biggest brokerage firms priced securities caught up in the subprime meltdown as their values collapsed. My colleague Jonathan Weil last week detailed some of the accounting shenanigans that accompany how banks measure the "fair value'' of their assets.

What happens if the SEC discovers that different units of a single bank assign different values to identical securities? That seems like a viable scenario for what might happen when a complex market of infrequently traded securities whose prices are dependent on a series of assumptions hits trouble.

And what happens if the SEC finds that banks marked the securities they owned at high prices, while attributing much lower values to identical securities offered by their hedge-fund clients as collateral? Again, that seems like a plausible strategy for a bank concerned about the longevity and liquidity of its customers.

Suppose regulators decide to play hardball on how the financial community marks to market, imposing rules that outlaw the existing freewheeling approach to how over-the-counter derivatives are assayed.

Moreover, suppose those new decrees come just as much of the underlying collateral is so tarnished as to be almost worthless compared with its initial valuation.

The ensuing carnage in the balance sheets of every financial-services company in the world would dwarf the damage wrought in the securities industry by the subprime crisis so far.

Bloomberg.com: Unsafe at Any Rating, CDO Speeds to CCC From AAA: Mark Gilbert

via pmarca