Level 3 Assets: Credit's Next Concern

Posted by urbandigs

Sat Nov 3rd, 2007 10:17 PM

A: I want to discuss what will soon be in the media alot, as round 2 of the credit crunch already is underway! First off, I don't care what CEO's get fired or how many rate cuts printing press Ben Bernanke does, the credit crisis problems lie so deep that these actions will not cure the disease; it will only provide some temporary relief as the problem phases itself out. What we need to look out for now, is what round 3 of the credit crunch may be caused by. I think it will be lowered valuations for Level 3 Assets. On November 15th, a new accounting rule will require the disclosure of these assets whose market valuations were assigned by in-house models, as the market where they trade in are illiquid and in distress.level-3-assets-credit-crisis-insolvency.jpg

LEVEL 3 ASSETS (via Marketwatch.com) - Level 3 assets are those that trade so infrequently that there is virtually no reliable market price for them, and valuations for these assets are based on management assumptions.

Problems people! I've discussed many times in the past few months how the markets for these CDO's, CMO's, and other mortgage backed securities have seized up. There are just no bids and no volume, making no market!

Now, what we do know is that brokerages, banks, hedge funds, and other institutions are holding very complicated assets whose actual value has virtually vanished. The key word here is actual, or real market value. But these level 3 assets are NOT being marketed to the real market! They are being held, hidden on the books of major corporations and institutions, as management places their best-guess valuations that are almost always grossly overvalued!

Round 3 of the credit crunch will be the 'coming out' of sorts of the adjusted valuations of these level 3 assets leading to the uncovering of major losses to the most exposed corporations and institutions. I think this process will take months to play out and we are heading right into the heart of storm as November 15th approaches.

RULE SFAS157 (via PrudentBear.com):

From November 15, we will have a new tool for figuring out how much toxic waste is in investment banks' balance sheets. The new US accounting rule SFAS157 requires banks to divide their tradable assets into three "levels" according to how easy it is to get a market price for them. Level 1 assets have quoted prices in active markets. At the other extreme Level 3 assets have only unobservable inputs to measure value and are thus valued by reference to the banks' own models.
To get an idea of the potential size of this problem, here is what I was able to find that is somewhat fresh news.

GOLDMAN SACHS - said Wednesday (OCT 10th) the size of its level 3 assets at the end of third quarter increased to $72.05 billion from $54 billion at the end of the second quarter.

In terms of percentage, the New York-based investment bank's third-quarter level 3 assets amounted to 7% of the total assets, compared with about 6% at the end of the second quarter.

PrudentBear.com continues:
Figures that have been disclosed show Lehman with $22 billion in Level 3 assets, 100% of capital, Bear Stearns with $20 billion, 155% of capital, and J P Morgan Chase with about $60 billion, 50% of capital. However those figures are almost certainly low; the border between Level 2 and Level 3 is a fuzzy one and it is unquestionably in the interest of banks to classify as many of their assets as possible as Level 2, where analysts won't worry about them, rather than Level 3, where analyst concern is likely.
So far, subprime mortgages and the derivative products associated with them has caused round 1 and round 2 of the credit crunch. We saw what effect it has on the markets when Merill, Wells Fargo, Citigroup, Bear Sterns, Bank of America, and Washington Mutual write down losses far exceeding original estimations. But there are far more assets out there whose valuations have been guessed at and will soon be classified under the level 3 category. As the PrudentBear.com article points out, these include:

a) Alt-A & Prime Mortgage Backed Securities - As home prices fall, debt-to-equity ratios rise. As ratios pass 100% of original loan-to-value, the mortgage becomes "uncovered", and the securities related to them become unmarketable level 3 classified assets whose value gets assigned by management
b) Securitized Credit Card Obligations - $915B credit card debt outstanding
c) Leveraged Buyout Bridge Loans
d) Asset Backed Commercial Paper - Slowing market from $1.2Trillion to $900Billion in past 3 months
e) Credit Default Swaps - Hello ABX Indices; we discussed the plunge here
f) Complex Derivative Contracts - Interest Rate & Currency swaps

According to The Business:
It's the level 3 assets that must concern investors more than ever as they are marked to in-house models. Those models are more art than science and are subject to the banks' judgment.

Much of the attention of such Level 3 assets has been focussed on mortgage-related assets. But they also include complex derivative contracts, credit card receivables, loans linked to leveraged buyout loans and asset backed commercial paper. From Nov. 15, the Level 3 disclosures will be accompanied by details of the basis on which they are classified.
It's the balance sheets that will define round 3 of the credit crunch as the value of level 3 assets gets disclosed to investors. Hard to imagine how the assigned valuations of these un-tradable assets rise; instead, expect to see significant write-downs and more distress as we work through this process.