Rising Tide of Level 3 Assets: Disaster Waiting to Happen

From Seeking Alpha
By Jennifer Yousfi

In the first quarter, Goldman Sachs Group Inc. (GS) packed another $27 billion worth of illiquid assets onto its balance sheet - a 39% increase that brought the total to $96 billion.

And Goldman wasn’t alone. Morgan Stanley (MS) reported that these hard-to-value/hard-to-sell assets soared 45%, reaching $32 billion. For Lehman Brothers Holdings Inc. (LEH), the first quarter increase was $500 million, bringing its total to $42.5 billion.

The balance-sheet holdings in question are known as "Level 3" assets. And with the smoke from the subprime-mortgage crisis still hanging over Wall Street like the fallout from a nuclear missile strike, some industry observers are worried that the difficult-to-sell Level 3 assets are little more than a crisis-in-waiting that’s standing in the wings of the U.S. financial-services sector.

And now that banks and brokerages are well into their first-quarter earnings reports, it’s clear that the amount of these tough-to-value assets are climbing on the balance sheets of such banking-sector stalwarts as Goldman, Merrill, Lehman - and others, too.

But the real question is - why?

That question has put investors back on the defensive.

Money Morning Contributing Editor Martin Hutchinson - an expert on the international debt markets - had a succinct answer.

"Level 3 assets are yet another disaster waiting to happen," Hutchinson said in an interview.

Accounting rules require financial firms to price the assets on their balance sheets at a so-called "fair value." As part of that, financial assets are broken down into three categories, or "levels," based upon how liquid the assets are and, in turn, how easy they are to value, or price:

• Level 1 assets are fully liquid, and easy to price.
• Level 2 assets can be priced with the benefit of "comparable assets."
• And Level 3 assets are completely illiquid and nearly impossible to price.

In the attempt to explain what’s happening in the market - in short, why the amount of Level 3 assets are increasing on financial-sector-firm balance sheets - two theories have emerged. And neither one bodes well for the longed-for end to the global financial crisis that was kicked off by the collapse of the subprime mortgage sector.

One of two things is occurring. Either:

1. Investment banks are reclassifying Level 2 assets as Level 3 assets, for a reason we’ll explain momentarily.
2. Or the brokerage firms are inflating their estimates for the value of Level 3 assets already on their books.

Even worse - it could be a combination of both.

Prior to the current credit mess, mortgage-backed securities were priced according to Markit’s ABX Index, which used the average weight of four series in the index to track the price of housing derivatives. But once the subprime market collapsed, the ABX Index plunged - and has yet to recover.

With the first scenario, rather than mark down its Level 2 assets to the current abysmal levels of the ABX, Goldman has decided to simply reclassify those assets as Level 3 assets, experts say. If there isn’t an actual "market" in which to sell the securities, the banks don’t have to write down the price of the assets; indeed, they can list any value they want, theoretically.

"Goldman is the one house that hasn’t had any losses," Money Morning Contributing Editor Martin Hutchinson said in an interview. "That, in itself, is suspicious."

This kind of thinking might seem shocking to a non-Wall Streeter, but it’s common practice in modern accounting.

In the second scenario, some experts say it’s possible the investment banks are inflating the price of the level 3 assets already on their books. Since, in theory, there is no market for a Level 3 asset, they are impossible to "mark-to-market." Financial firms use various in-house pricing models to determine a price for these assets. The firms would likely argue stridently that the pricing models they employ are valid and can be fully justified. But the reality is that - in the end - the price they mark down in the corporate ledger is basically a made-up number.

Boosting the value of assets can staunch a bleeding balance sheet. We’ve seen the damage $300 billion worth of mark-to-market write-downs has done to the global financial sector.

After all that carnage, imagine what a reversal of this write-down hemorrhaging could mean?

"If you can make up a higher price, you can pay yourself a higher bonus," Hutchinson said.

At the same time, firms such as Goldman also boosted the collateral they can use to secure loans, even though no one is likely buy that collateral - not at any price. But with the U.S. Federal Reserve’s new lending program, investment firms such as Goldman can use Level 3 assets to secure highly liquid U.S. Treasury loans.

The bottom line is that you just don’t know if you can trust the valuation of Level 3 assets. In a true recession, it’s possible the value of those assets could go as low as zero.

With Level 3 assets currently representing 14% of Lehman’s total assets, and 13% of Goldman’s, a recession that drops the bottom out of the market could mean billions more in additional write-downs.

"People are concerned about Level 3 [assets] because of possible write-downs, though it isn’t all necessarily losing value," Erin Archer, a senior equity research analyst at Thrivent Financial for Lutherans, told Bloomberg News. "We aren’t out of the woods yet when it comes to write-downs and the profitability of brokers."

Thrivent holds shares of Goldman, Morgan and Lehman among the $73 billion it has under management.