From today’s FT:
The biggest US financial institutions reported a sharp increase to $610bn in so-called hard-to-value assets during the third quarter, raising concerns about the hidden dangers on balance sheets.
So-called level-three assets, classified as hard to value and hard to sell, rose 15.5 per cent from the second quarter, according to analysis by the Market, Credit and Risk Strategies group of Standard & Poor’s.
Translation: Banks are hiding more and more assets that no one wants.
Lest we forget level 1, level 2 and level 3 assets are ways of classifying company’s assets based on how certain you are of their value, created by the FASB’s Statement 157. Level 1 assets have readily identifiable market prices. Level 2 assets have comparable market prices or models. And Level 3 assets are based on something called “unobservable inputs” that “reflect management’s own assumptions.” In other words, they’re worth whatever the banks think they are, or perhaps more accurately, want them to be worth.
Yves Smith at Naked Capitalism puts it well:
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.”
Of course, mark to make believe (M2MB) is a popular activity amongst the banks. Lehman for instance, added something like $1.4bn to its level 3 assets shortly before going bust (those level 3 assets were also something David Einhorn looked at before deciding to short the bank’s shares).
Interestingly, the FT article and other commentators suggest that more Level 3 assets mean more writedowns. We’re not so sure.
Our impression was that the whole point of classifying stuff as Level 3 was so that you could avoid taking massive writedowns on illiquid assets. This Bloomberg article, for example, suggests that Wells Fargo’s record 2007 Q1 results were boosted by a $1.21bn net gain in Level 3 assets — without which its earnings would have declined significantly.
In any case, Goldman Sachs and Morgan Stanley are due to report their fourth-quarter results next week. Watch how much goes into those level 3 assets.
As the Bloomberg story notes:
“If you see a big chunk of earnings coming from revaluations involving Level 3 inputs, your antennae should go up,” says Jack Ciesielski, publisher of the Analyst’s Accounting Observer research service in Baltimore. “It’s akin to voodoo.”
Related links:
Wells Fargo gorges on mark-to-make-believe gains - Bloomberg
Level 3 Asset Analysis - EconomPic Data
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