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.

So Where Are We In The Housing Bubble?

So I'm reading Diana Olick's blog on CNBC about the housing bubble and she's voicing her frustration with the repeated "on camera" question: Have we hit bottom yet?

To which she replies, it depends on the market (and since I'm in the thick of it here just north of Stockton, CA, I have to agree) with most notibly California and a majority of the West Coast having seen the largest percentage drop around the country over the last month. Great, nothing I haven't heard.. honest reporting.. time to move on.. BUT wait, she puts a link to the Zillow blog at the bottom of the page for some regional stats.

Now if you click on the image, it will take you to the Zillow "Zindex" site that has the interactive data for 66 MSA's from around the country. Each vertical bar represents a city's year over year housing appreciation (red) or depreciation (blue) - the green bar represents the "Zindex" for the full MSA in that market. Interesting visual format.

You can slide the mouse over each bar in the MSA to get a closer look at each community's housing price change year over year. What is startling confirms what my neighbors and friends are saying is happening in our market (Stockton/Sacramento/Central Valley) and the "grand exitos" from Northern California into Oregon and Washington over the past year. Each one of these markets is red on the site and most are up substantially. They did not include the Boise, ID market, but my hunch is that it would trend higher as well. From the visual data, it is easy to see where we are at regionally and nationally.

Two other interesting credit market notes in the news today:

1. Noting that the UK is not faring much better with the credit crunch, it was reported that BarclayCard has reduced its spending limits on 500k credit card holders today. Effectively they have closed off any credit that marginal cardholders might need if they show difficulty handling existing levels of personal debt. I'm sure that this is one trend that might make it's way to the States, just in time for Holiday shopping.
2. Eric Englund (credit professional for the past 23 years) provides an editorial in Financial Sense on the credit "crisis" and how we got to this point (very interesting read). But, I was most interested in the statistics of just how high domestic household debt has risen in twenty years:

Regrettably, when the Federal Reserve targeted housing to reflate the U.S. economy with enormous doses of money and credit, America’s creeping credit socialism was given fertile ground to grow into a monstrous housing bubble. Mortgage lenders irresponsibly said "yes" to just about any borrower while Alan Greenspan cheered them on. It is no wonder why I have seen the most debt-laden, maladjusted personal financial statements in my entire career. In fact, the Federal Reserve’s data support my observations as domestic household debt has increased from approximately $2.5 trillion in 1986, to $7.7 trillion in 2001, to $12.9 trillion in 2006 (with 76% of the 2006 figure being mortgage debt). The toxic combination of mind-numbing inflation and credit socialism has crippled household finances from coast to coast. Therefore, do not believe the talking heads who claim that the mortgage mess is limited to the subprime stratum. As the housing bubble continues to implode, the financial fallout will result in nothing short of an international economic disaster. The Federal Reserve’s September 18, 2007 one-half percent cut in the fed funds rate will not do anything to head off America’s looming household-insolvency crisis.

Doom and Gloom within a month?

On light volume with consumer confidence waning and the Fed minutes indicating that they "might" have known that a credit crunch was coming, the market technicals indicate a continual downturn in the markets. In the news today, National home sales continue to slump; the San Diego housing starts are down 37 percent from last year; another capital management firm must liquidate a multi-billion dollar fund; and, a 21-year veteran of the US Treasury Dept and NASA offered one of the gravest predictions I've seen thus far. Let's hope he's only half right:

On Market Predictions in the Current Chaotic Environment.

by Richard C. Cook

Global Research, August 28, 2007

No one can predict how deep the decline in Western economies that is underway will go, because there is so little transparent information. Within the U.S., the government is hiding the severity of the crisis in order to prevent a collapse of consumer confidence.

Realize that the problem does not lie on the side of production. Global industry has the capacity to produce a huge quantity of goods and services. There is even a glut in some sectors, such as automobiles, textiles, IT, and other consumer products.

Rather the problem, as with the Great Depression, is that purchasing power at the consumer level is lacking. In the U.S., purchasing power, as measured by M1, is already in a recession-level decline. The causes are the high level of consumer debt, high cumulative levels of taxation on the dwindling middle class, and the tragic erosion of wages and salaries from job outsourcing.

In the absence of purchasing power, the Federal Reserve has chosen the strategy of trying to outrun collapse by creating inflation. This is the meaning of the bail-outs that are going on. It’s an attempt to devalue debt at the macro level. It’s a hidden tax on everyone but the super-rich. Everyone else is poorer today than they were yesterday.

How long this can go on is unpredictable. It’s another bubble following on the housing and asset bubbles that are already bursting on a daily basis before our eyes.

I don’t see any responsible analyst who foresees any better outcome than a recession that would see the DJIA at a level of 8000-8500 within a few months. Again, maybe the Fed’s printing presses can hold this level of decline at bay for a while longer, but I doubt it.

There are major players in the markets who see an even steeper decline coming even sooner. Some say as soon as a month.

There is also a real chance of an eventual depression-level contraction. How much of a chance, I don’t know. This conceivably could lead to a total collapse of consumer markets, economic paralysis, and widespread homelessness and starvation. Yes, even in the U.S. Agribusiness, bio-fuel conversion, seedless mega-farming, the disappearance of family farming, and the recent disastrous weather conditions place everyone at risk.

At some point, the federal government, at a minimum, has to step in with New Deal-type relief measures. Whether the Bush administration has that capability is doubtful. Look at New Orleans. They may even try to cover everything up by starting a war against Iran. Are they that crazy? Who can say?

There are also rumors going around that there are plans to allow the markets to be crashed by a terrorist event so as to divert blame. I have gotten no reliable confirmation of these rumors, though there are parties placing what people in the markets are calling “bin Laden”-type bets similar to, but bigger than, the “puts” that were placed before the original 9/11.

These types of bets have been placed in the U.S., European, and Japanese markets that assume a stock market crash of fifty percent within the next five weeks. A report was just carried, I’m told, on CNBC.

Some have said the culprit may be China, but it makes no sense for the Chinese to crash the markets while holding U.S. dollars. Others say it is hedge funds at work to try to drive down the markets in a self-fulfilling prophecy.

But a fifty percent market decline? That’s just not conceivable. Even the hedge funds do not have that much power. The federal plunge protection team—known as the “men in black” by floor traders—would never allow them to do something so disastrous. This has caused some to speculate that the “men in black” are parties to the bets.

These remarks probably give some indication of the chaos going on right now in the U.S. and world economies. The only real solution is a new world financial system based on the concept of credit as a public utility. This is what should be implemented to replace the present system of institutionalized usury.