Last fall, I shared with Minyanville readers that Washington Mutual (WM) had, to use the company's own word, “opportunistically” moved a large portion of its “held for sale” mortgages into its “held to maturity” portfolio.

At the time, management suggested that the reason was because of the attractive pricing that it saw on the loans. As I wrote then, and continue to feel now, I believe that the real reason was the difference in accounting for banks between “held for sale” and “held to maturity” assets.

Put simply, for banks, “held for sale assets” must be marked-to-market every quarter, with the changes in unrealized gains or losses flowing through comprehensive income – and I would note up front, not net income. (For more on this topic, please see Banking 101 or 102, where I talk about the importance of comprehensive income versus net income, especially for financial institution investors).

While “held to maturity” assets remain at cost (or market value as of the day of reclassification, if moved to “held to maturity” from “held for sale”) and, like other loan assets, only when management is certain of cashflow impairment, are they written down.

As I have seen in a number of second quarter bank 10-K’s and in financial media, it now appears that banks are moving other assets at a rapid pace from “held for sale” to “held to maturity.” Specifically, the assets that banks moved most during the second quarter appear to be largely trust preferreds as well as CDO’s from pooled trust preferreds issued by other financial institutions.

But why? As one bank wrote in its second quarter report:

“Over the course of the first six months of 2008, the market for trust-preferred securities became increasingly illiquid, due to negative perceptions about the health of the financial sector in general, and the financial stability of the underlying issuers, in particular. This environment made it difficult to determine a fair value for these securities as of June 30, 2008, and to determine whether or not they had become other-than-temporarily impaired.

“… The transfer will reduce the volatility and future negative effect on our capital ratios, because held-to-maturity securities are not marked-to-market through other comprehensive income, but carried at their amortized cost basis.”

For Wells Fargo (WFC), which was the focus of some attention, “mark-to-market” valuation changes were pretty significant during the second quarter. While the company reported net income of $1.753 in net income, that figure excluded almost $950 million of unrealized securities losses that flowed through comprehensive income, and, therefore, capital. And for other banks, the impact was even more severe.

With the reclassification of “held for sale” assets to “held to maturity,” Wells Fargo and other banks no longer need to worry about what happens to the market price for these assets, but rather what happens to their underlying cash flows. But like the subjectivity in setting loan loss reserves, it will be only when management sees a loss coming that it will take it.

My fear, if I have one, is that this is yet another example of bank management operating under the assumption that this is just a normal credit cycle correction.

Where time is their friend, and if they can just hold on longer enough, the market will recover and these assets will ultimately perform. But in the specific Wells Fargo case highlighted by the WSJ, the reclassed securities that we are talking about today were issued by fellow financial institutions, so yet again, rather than defusing the situation today, we're postponing out into the future the day of reckoning for yet another risk of our “too entwined to fail” financial system.