Lenders Face Still More Misery

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Those aren't the only profits that may vanish. Big banks also recorded earnings up front from mortgage-backed securities they created and sold to investors. Here's how the accounting maneuver, known as "gain on sale," works. Say a lender bundles together a group of mortgages valued at $2 billion. Over the life of the bond—as long as 30 years—the bank will collect an estimated $100 million in cash flows from that security. That money comes from interest, servicing rights, and other payments. The bank counts the $100 million as income once the security is sold, even though it won't actually get those payments for years to come.

It's a perfectly legitimate, but controversial, move. Consider the fate of Conseco (CNO) . At the start of the decade, the firm, which specialized in risky mortgages on mobile homes, took a massive hit from writedowns related to profits previously reported through "gain on sale." The company ultimately filed for bankruptcy in 2002.

Reflecting Reality?

In this boom, Countrywide has applied the rule more aggressively than any other major player in the industry. Such gains accounted for 48.4% of operating income at Countrywide over the past three years. The lender, which Bank of America (BAC) agreed to buy in January, has started to take writedowns connected to those profits. But some analysts figure more losses are inevitable. BofA declined to comment.

Analysts and auditors are also taking a close look at a category of mortgages on balance sheets called "loans held for investment." During the housing heyday, lenders largely put loans they made to homeowners or bought from other brokers into a bin referred to as "loans held for sale" until Wall Street bought them to repackage into securities. The value on those loans must reflect the current market conditions—which are bleak.

Some banks are now reclassifying those pools as "loans held for investment." If they fall into that category, banks have "more leeway" in valuing those loans, says Dorsey L. Baskin Jr., a partner at the accounting firm Grant Thornton. Banks don't necessarily have to mark down the value of those loans if they consider the losses temporary rather than permanent.

That leaves room for interpretation. WaMu moved $17 billion of loans into this category, taking down the value by 1%. Countrywide, in a similar transfer, slashed the value of $21.8 billion of mortgages by 5%. Says a WaMu spokesman: "The loans were performing at the time they were moved."

But some question whether those cuts are deep enough, given the severity of the market's woes. "All we know is the value of questionable assets is declining," says David Darst, chief investment strategist of Morgan Stanley's (MS) Global Wealth Management Group. "But are the writedowns 'mark to make-believe?"

Der Hovanesian is Banking editor for BusinessWeek in New York .