April 23 (Bloomberg) -- Here's Rule No. 1 from Wall Street's public-relations playbook: If the company you run has big losses on hard-to-value assets, scream your head off about the accounting rules.

And what if the squishy values result in huge gains instead, as they have in the not-so-distant past? Rule No. 2: Stay mum about it for as long as the rules allow.

For months, we've seen a growing parade of executives and politicians complain that fair-value accounting rules are to blame for financial institutions' imploding balance sheets. Even the International Monetary Fund got in on the act in an April 8 report, suggesting the need for ``some latitude in the strict application of fair value accounting during stressful events.''

There has been no commensurate outrage about fuzzy mark-to- market accounting that lets companies post unrealized gains on illiquid balance-sheet items. Yet if it weren't for large non- cash profits on hard-to-value holdings, Goldman Sachs Group Inc. wouldn't have had much profit last quarter. Lehman Brothers Holdings Inc. would have had significantly less. And Morgan Stanley wouldn't have had any.

You wouldn't have known those things from the earnings press releases the three investment banks issued in mid-March. Investors had to wait until a few weeks later to find out. That's when the banks filed their quarterly financial statements, including footnotes showing changes in their so-called Level 3 assets and liabilities.

The rules allow such delays. What's amazing is that the banks' investors aren't demanding to get this information sooner.

Making Assumptions

First, here's a quick fair-value primer. Under the rules known as Financial Accounting Standard No. 157, Level 1 means mark-to-market. You look up a market quote -- say, a stock price on the Nasdaq -- put it on your balance sheet and run changes through earnings each quarter. Level 2 is mark-to-model. Quoted prices don't exist. So you estimate values using other inputs observable in the market.

Under FAS 157, Level 3 means the value of a given item includes at least one significant ``unobservable'' input, reflecting a company's ``own assumptions about the assumptions market participants would use in pricing the asset or liability.'' Or, as I like to say, mark-to-make-believe.

There isn't anything necessarily wrong with Level 3 measurements. By definition, though, they are less certain and more prone to bias. There's nothing new about Level 3 gains and losses either. They just weren't called Level 3 before FAS 157, which the major investment banks adopted last year, and didn't have to be disclosed.

Break Down

Here's how the numbers break down. For the quarter ended Feb. 29, Morgan Stanley reported $4.24 billion of net unrealized gains on Level 3 assets and liabilities. That was almost twice the company's $2.21 billion of pretax income.

Those figures included $8.39 billion of net gains on Level 3 derivative contracts, driven in large part by adjustments on credit-default swaps, which Morgan Stanley used to buy protection against declines in the creditworthiness of various holdings.

Morgan Stanley included the $8.39 billion on its income statement as part of trading revenue, which was $3.39 billion last quarter. So, without those items, Morgan Stanley's trading revenue would have been negative $5 billion. (Yes, negative.)

At Goldman, net unrealized Level 3 gains were $2.07 billion for the quarter ended Feb. 29, equivalent to 96 percent of the company's $2.14 billion of pretax income.

Offsetting Moves

Goldman spokesman Lucas van Praag stressed that the bank's unrealized Level 3 gains principally were ``due to observable moves on our derivative portfolio and not to changes in Level 3 inputs'' that were unobservable.

He also noted that ``Level 3 assets are often hedged by Level 1 or Level 2 assets.''

Morgan Stanley spokesman Mark Lake pointed to similar disclosures in his company's quarterly report. To be sure, in instances where such Level 3 assets are rising in value, that also means the gains may be less certain than the corresponding Level 1 and Level 2 losses from hedges.

Lehman booked $695 million of non-cash gains last quarter on corporate equities classified as Level 3, slightly more than the company's $663 million of pretax income.

The company showed $9.38 billion of such equities as of Feb. 29. The gains suggest a remarkable performance; the Standard & Poor's 500 Index fell 10 percent during the same period.

Overall, Lehman booked $114 million of net unrealized Level 3 gains last quarter, equivalent to 17 percent of pretax income.

Lehman spokeswoman Kerrie Cohen said the unrealized gains on Level 3 equities ``were related to certain positions of principal investing activities and private equity-related positions.'' She said the firm ``does not disclose or discuss individual investments or transactions.''

Back in Balance

The point here isn't to challenge the accuracy of these companies' results. It's just time to restore some balance in the public debate over fair-value accounting. The best reason for allowing Level 3 gains at all is the promise that the rules will keep companies honest about the downside, too.

For instance, if American International Group Inc.'s $11.5 billion of markdowns on ``super senior'' credit-default swaps during the fourth quarter were illusory, as AIG has complained, then it would stand to reason that much of Morgan Stanley's profits last quarter were, too. Perhaps the reality might lie somewhere in between. The safest bet for investors, though, is to be skeptical of both companies.

(Jonathan Weil is a Bloomberg News columnist. The opinions expressed are his own.)

To contact the writer of this column: Jonathan Weil in Boulder, Colorado, at jweil6@bloomberg.net

Last Updated: April 23, 2008 02:26 EDT