Level Three Assets: banks are hiding the ball on credit writedowns

Yves Smith has a good post over at Naked Capitalism that brings attention to the fact that banks are hiding potential losses in Level Three assets. Ultimately, these losses are going to have to be recorded and that means more credit writedowns and a larger bailout for the financial services sector.  You have been warned.

Yves notes in her post that this behavior is being sanctioned bu U.S. regulators.

Readers may recall that the Financial Standards Accounting Board implemented Statement 157, which required financial firms to identify how they arrived at the “fair value” for their assets. Level 1 are ones where there is a market price. Level 2 are those where there may not be much of a market, but they can nevertheless be priced in reference to similar assets that have a market price.

Then we have Level 3. They are priced using “unobservable inputs.” I have never understood this concept, because the use of sunspots, skirt lengths, the Mayan calendar, or a model using, say, a ratio of bullish versus bearish stories on Bloomberg would be an observable input. And fittingly, Level 3 is colloquially called “mark to make believe.”

And there are indeed signs that indicate that financial firms have played fast and loose with this rule:

1. In the first quarter of 2007, Wells Fargo created $1.21 billion of Level 3 gains. Without them, it would have posted a loss.

2. Lehman added more assets to the Level 3 category at a time when better trading conditions said it should have been lowering them
However, it is now completely kosher to play games. While the three-level hierarchy became effective on January 1 of this year (some firms chose to comply early), the SEC largely gutted it in the wake of the Bear collapse. From its March press release:

Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale (boldface ours).

Edward here again, I noted back in June what was going on in a post called De-leveraging redux.  My analysis and conclusions bear noting in conjunction with Yves’ analysis.

FAS 157
FASB (the Financial Accounting Standards Board) is the U.S. accounting group that delivers edicts that U.S. listed companies must follow in order to meet U.S. accounting standards under U.S. GAAP (Generally Accepted Accounting Principles). What they say goes in U.S. accounting. (This is the same group that roiled technology stocks when it issued an FAS123R to begin expensing employee stock options). They issue edict called FAS numbers, which update accounting standards in the U.S. to new guidelines.

They issued an edict called FAS 157 that went into effect on 15 November 2007, that has major implicatins for how banks riskiness is viewed by investors. The day the edict went into effect of the edict, the Wall Street Journal described it like this:

Many investors, thanks to the banks’ early adoption of FAS 157, have already become pretty familiar with its disclosures based on what are called Level 1, 2, and 3 assets. These buckets are meant to show investors the amount of certainty that pertains to the valuation of a financial asset.

Level 1 is assets that have observable market prices. Think a stock traded on the NYSE. Level 2 assets don’t have an observable price, but they have inputs that are based on them. Think an interest-rate swap where its components are observable data points like the price of a 10-year Treasury bond.

Level 3 is for assets where one or more of those inputs don’t have observable prices. This is the bucket that has been described as a guesstimate, because it is reliant on management estimates. As things stand now, companies who haven’t early adopted FAS 157 don’t give this more detailed breakdown to investors. So, one result of FAS 157 is more information.

That has prompted investors to pay more attention to the way companies price hard-to-value Level 3 assets. In that sense, FAS 157 isn’t forcing companies to write down prices because of the current market turmoil. It is more a case that the new disclosures will cause investors, and regulators, to ask a lot more questions if it looks like a company isn’t taking adequate writedowns.

One other change is that FAS 157 makes it clearer that companies, if they have to value something using a model, have to think in terms of the value that would result if they were selling, or exiting, the position. In other words, they have to take current market pricing and conditions into account.

–Wall Street Journal, 15 Nov 2007

This edict is at the core off problems for financial institutions, particularly investment banks like Bear Stearns, Lehman Brothers, Goldman Sachs, Morgan Stanley, and Merrill Lynch. These institutions have large amounts of Level 3 assets, meaning their balance sheets are rather opaque and subject to surprise massive writedowns when these market dislocations occur.

Conclusions
So, that’s the story of deleveraging in a nut shell. Financial institutions have either too little capital and risk credit downgrades like the ones we saw two days ago. Or they have way too much Level 3 assets on their balance sheet – risky, junky assets that are hard to value. Or both.

This is why you see financial institutions going cap in hand to Sovereign Wealth Funds for additional capital. This is why Bradford & Bingley was so distressed it needed to sell equity at a huge discount to TPG, the American buyout shop. This is why Bear Stearns went under and why Lehman Brothers is being scrutinised.

Finally, in a world of deleveraging — where banks are looking to dump Level 3 assets at any price and raise additional capital now — credit is hard to come by. And it is this credit crunch that is the worry. Credit crunches have an unpleasant way of becoming depressions.

Now, I wrote this in June. And the message is still the same today. Obviously, the banks are hoping that price falls are only temporary and are therefore resisting writing these assets down as their capital bases are already seriously impaired. To my mind, hiding the ball this way only insures that this problem will get worse because many of these writedowns will have to be taken eventually. This sounds like a repeat of the types of loopholes used during the S&L crisis in the 1980s when bankrupt Savings and Loan institutions were allowed to continue operating, eventually costing U.S. taxpayers much more.

You should be left understanding two things:

1. The level three practices are ticking time bombs exposing us all to potentially much greater losses.
2. These activities are given cover by U.S. regulators because they are concerned about the magnitude of the problem.

This all certainly speaks to the need for some serious price discovery in order to eliminate the truly opaque nature of all of this.

Sources
Quelle Surprise! Banks Increase “Mark to Make-Believe” Assets to $610 Billion – Naked Capitalism
Level Three Assets Said to Rise at Major Banks – Deal Book
Financial groups’ problem assets hit $610bn – Financial Times