I’ve posted before about my skepticism towards financial statements in general. This problem is compounded when dealing with financial reports from financial services companies, making them about as useful as toilet paper in times of financial turmoil (except that toilet paper is softer — which makes these financial reports even less useful than toilet paper I suppose).
The reason for this is that the business models of these financial services firms are highly dependent on something I’m going to call “non-real” assets — instead of converting raw materials and labor into a product (intellectual or physical) to sell, they depend upon price movements in financial markets, on credit risk, and on leverage (borrowing other people’s money). Now this is not an angry tirade that the financial services industry is worthless (somebody must think what they’re doing is worthwhile if they’re paying them so much) but merely my illustrating that the assets and holdings a financial services claims to have are oftentimes illusory by virtue of the fact that these firms make money by watching these assets and holdings change market value.
This distinction between “real” and “non-real” is difficult to make given that “real” companies also have to deal with similar issues (e.g. a steel company’s holdings will be worthless if we all stop using steel), but I believe it’s a useful tool to understand the current credit crisis. In a nutshell, the financial services industry is reeling from broken markets, debtors defaulting like crazy, and creditors calling in loans and being reluctant to make new ones. As a result, the profit engine for the industry has come to a sudden and sputtering stop, orders of magnitude worse than what you would expect just by looking at their financial statements from last year.
This problem — that investors can’t really gauge what a financial service company is doing through official financial documents — is made even worse when you consider that one common tactic banks have used in recent years is to create Structured Investment Vehicles (SIVs), a practice which is tantamount to creating new companies who’s sole purpose is to invest the money of the parent bank but with little public scrutiny. This arrangement lets the bank make risky investments “off balance sheet” — or, in other words, make investments which don’t show up anywhere in official financial reports unless, as has been happening recently, the investments 
suddenly become worthless.
As Marc Andreessen aptly points out (hat tip: A. Phan), “Remember Enron? Imagine Enron times a hundred.“
Given the IMF’s recent estimate that the subprime crisis will destroy $1 trillion of value, that means we are talking about nearly $200 of market value destruction for every single human being on Earth.
The solution? I’m not sure. I have doubt over how much “better” accounting standards can help thwart problems like the current credit crisis. Different accounting standards may help address the issue of off-balance sheet SIV holdings, but they can’t change the underlying fact that financial services firms make money from forces/factors which fundamentally make financial statements less useful. They also can’t prevent swarms of people from knowingly taking large risks. The only guidance from this is to be very wary of what you read — just like you can’t make money off of a tech company that has no product, you also can’t make money off of a financial services company that is holding worthless illiquid assets, no matter how much they claim on their balance sheet.