Monday, November 12, 2007

Level 3 Assets Are Surging

The FASB 157 rule is set to take effect on the brokerage houses, banks and financial institutions, in case you haven't noticed the latest 5 day drop in the Dow, S&P and Nasdaq. In today's Bloomberg article:

...Under the rule, Level 1 assets are those for which market prices are readily available. Level 2 holdings are valued based on ``observable inputs,'' or prices of similar assets traded in the market. Assets fall into the Level 3 category when there aren't even any observable inputs, and the firm has to rely on in-house models to calculate potential gains or losses... While those typically fall into the Level 3 category, assets such as leveraged loan commitments shift from one level to another depending on market conditions...

The Rule is specific about unobservable inputs (Level 3 category) and their intended use (FAS 157):

...The notion of unobservable inputs is intended to allow for situations in which there is little, if any, market activity for the asset or liability at the measurement date. In those situations, the reporting entity need not undertake all possible efforts to obtain information about market participant assumptions. However, the reporting entity must not ignore information about market participant assumptions that is reasonably available without undue cost and effort.

This Statement clarifies that market participant assumptions include assumptions about risk, for example, the risk inherent in a particular valuation technique used to measure fair value (such as a pricing model) and/or the risk inherent in the inputs to the valuation technique. A fair value measurement should include an adjustment for risk if market participants would include one in pricing the related asset or liability, even if the adjustment is difficult to determine. Therefore, a measurement (for example, a “mark-to-model” measurement) that does not include an adjustment for risk would not represent a fair value measurement if market participants would include one in pricing the related asset or liability...

As these real estate assets are lumped into the Level 3 category on the financial institutions' books, the value of the write-downs are going to become larger as we've been seeing in the past week (Bloomberg):

...Goldman's Level 3 assets, for which market prices are so scarce that companies use internal models to gauge their value, accounted for 6.9 percent of the New York-based firm's $1.05 trillion total at the end of August, according to a filing with the U.S. Securities and Exchange Commission. Citigroup classified 5.7 percent of its assets as Level 3 on Sept. 30 and Merrill reported 2.5 percent.

Investors have grown wary of banks and brokerages with difficult-to-sell securities on their books, after profits at Citigroup and Merrill were crippled by at least $19 billion of writedowns, mostly from bonds backed by home loans to borrowers with poor credit histories. While Goldman officials say the firm won't report an ``extraordinary'' drop in its subprime holdings, investors remained skeptical, pushing its shares down 15 percent this month through yesterday in New York Stock Exchange composite trading.

``It's hard to believe Goldman is perfect,'' said Jon Fisher, who helps oversee $22 billion at Minneapolis-based Fifth Third Asset Management and sold his Goldman, Merrill and Morgan Stanley shares in the past 12 months. ``Their losses might be smaller than others, but that doesn't mean they don't have a problem.''...

It's the Fed's next move to determine if they're going to drop interest rates to curb these expanding portfolio losses on the Street, or keep interest rates in check with commodities to curb inflation on Main Street. In last week's post, Level 3 Assets Broken Down:

If we look at the major institutions and divide their Level III assets by their equity capital base, we arrive at the following calculations:

  • Citigroup: Equity base: $128 billion, Level III: $135 billion. Ratio: 105%
  • Goldman: $39 billion, Level III: $72 billion. Ratio: 185%.
  • Morgan Stanley: $35 billion. Level III: $88 billion. Ratio: 251%.
  • Bear Stearns: $13 billion. Level III: $20 billion. Ratio: 154%.
  • Merrill Lynch: $42 billion. Level III: $16 billion. Ratio: 38%.
Again, whether this "matters" remains to be seen. What I will offer, with some degree of certainty, is that Hank, Ben and the rest of the den are fully aware of this dynamic. That's likely why we saw such aggressive actions from global central banks and, to that end, why the Treasury is pushing the super-conduit emergency bailout plan.

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