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The Problem with Level 3 Assets

Posted on: July 23, 2008 - Email Article - Printable Version

Steve Murray

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Issues surrounding the credit markets still remain on many banks’ balance sheets. Level 3 assets are by no means a new thing, but merely play a new role in this environment. As financial institutions have taken write-downs of more than $300 billion, there still be more assets that banks have not written down to their correct value.

You would think that banks are trying to write-down all of the assets they possibly can, raise capital, and move on. This is true, but there are still many assets on the books that can’t be valued, and when firms like Citigroup [C: 7.08, -0.06 (-0.84%)] who intend to reduce their legacy and other assets by $500 billion in the next few years will need to take further write-downs.

So what are the different classifications of assets?

Level 1- Level one assets are assets which can be mark-to-market based off of the asset’s real price.

Level 2- Assets are marked to model. The underlying holding is not traded on an open market, but there is a reasonable estimated price based on observable inputs. These assets are harder to price than level 1 assets and require some of the firm’s own assumptions.

Level 3- For these assets, there is no liquid market for these assets. Because of this illiquid market, assets are marked-to-model on the firm’s internal valuation. Essentially the firm is marking them to whatever value they want to mark them at. This could be a hiding place on the balance sheet where firms intend to mark these assets down over time to not make it seem as bad now. The true value of level 3 assets may never be known as there is no correct or true way to mark them.

Many banks are increasing the amount of level 3 assets that they have on their books. Merrill Lynch [MER: 0.00, 0.00 (0.00%)] increased their risky assets to $82.4 billion from $68 billion at the end of 2007. When a company like Merrill increases their level 3 assets, it is for one of two reasons: 1. Assets that were on their book as mark-to-market no longer have a market to be valued on; 2. More level 3 assets have been purchased as the firm may see value in them. Most often it is not because of the latter of the two, as many banks are trying to free up their balance sheet to increase their tier 1 ratios.

Merrill is not as bad as some other investment banks on the street when you look at their level 3 assets to their tangible equity capital. Merrill is actually regarded as one of the strongest as they have a ratio of about 130%, many other firms on the street have ratios well above 225%.

One bank on the street, which has emerged as a leader in its ability to accurately predict these markets better than other firms, is Goldman Sachs [GS: 88.78, +2.02 (+2.33%)]. They were able to reduce level 3 assets from $96 billion to $78 billion at the end of the 2^nd quarter. These assets now only comprise roughly 7% of their balance sheet. Which makes me wonder, how have they been able to reduce these assets as other have increased them. The only possible way is that they sold them off, but were able to achieve reasonable pricing on them.

No investment bank is completely shielded from what may be the second wave of write-downs. These write-downs are going to come when it hurts the most, either at signs of recovery or during another downturn in financial sector. I would continue to stay away from non top-tier investment banks in the near future, as you will see more write-downs and capital raises in the near future…

-Steve Murray

Disclaimer: The mutual fund the author is associated with is long GS.

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