More Concern About Wall Street Bookkeeping

Reader Bernard pointed us to a story in Fortune, “Wall Street playing with more funny money.” The cause for pause is the rising tide of Level 3 assets.

By way of background, investment banks and other financial firms are subject to new accounting rules that require them to specify how they value their assets. Level 1 assets are ones whose prices can be readily obtained (i.e., they trade actively); Level 2 assets may not trade often, but they are very similar to assets that can be readily priced, so a Level 2 asset can be priced in relation to a similar (or several comparable) Level 1 instruments. Level 3 assets cannot be priced in relationship to actively traded assets. Many observers treat these values with considerable skepticism, calling them “mark to make believe.”

The Fortune article takes a dim view of the increasing amount of Level 3 assets that investment banks are carrying. It shows how, per the chart below, how the amount of Level 3 assets grew in the third quarter at all major firms. What it fails to mention is that in a sharply deteriorating market like last quarter, the last thing you want to be doing is taking on more risk, which is what an increase in difficult-to-trade assets entails.

The story also picks up on an argument pressed by Goldman: not all Level 3 assets are equally dubious. The firm claims, as Morgan Stanley does, that a fair amount of their Level 3 positions are real estate and private equity deals. That is comforting, but only up to a point. Even if their value is less subject to sudden decay than, say, collateralized debt obligations or exotic derivatives, they can seldom be sold for anything approaching “fair” value on a quick turnaround basis.

From Fortune:

Banks’ exposure to illiquid, hard-to-value assets jumped sharply higher in the third quarter, a development that deepens concerns about the transparency and strength of bank balance sheets….

It might sound like an increase in assets is a positive thing for a bank. But no financial institution wants to record a big increase in illiquid assets, because pricing and selling them is difficult and, if the credit crunch persists, many of them could be a source of large losses in coming quarters.

Investors have long been skeptical about the values that the banks themselves place on their level three assets, and that mistrust deepened after both Merrill and Citigroup (Charts, Fortune 500) recently revealed huge mortgage-related losses that were much bigger than outsiders had expected….

Investor frustration about the lack of transparency in banks’ balance sheets have contributed to the recent slump in bank stocks, which are down 12% since the end of Sept., according to the KBW Banks Index. And even if credit markets stabilize for some assets, and lead some banks to record non-cash, unrealized gains on level three assets, those profits won’t be considered anywhere near as dependable as earnings from more liquid assets…

Of course, no bank’s level three assets are going to be marked down to zero, so the comparison with equity doesn’t mean these assets could potentially wipe away all or most of a bank’s net worth. However, since future losses are most likely to come from level three asset markdowns, a comparison with equity makes sense, because the losses will immediately cause a hit to equity – and banks need strong equity to grow and maintain high credit ratings…

But focusing only on level three assets would be a mistake, because banks could also be holding assets at disputable values in their level two buckets. For example, some of the CDOs that Merrill marked down in its third quarter were shifted from level two to level three. To be sure, in the second quarter, those CDOs may have been correctly classified as level two, but the movement of assets between levels at Merrill shows that these regulatory classifications are frustratingly fluid. Since banks typically don’t disclose gains and losses from level two assets, this part of their balance sheet is likely to remain opaque.

Much hope has been placed on banks’ auditors making sure that assets are properly valued, especially those marked according to internal guesstimates. In October, the Center for Audit Quality, which represents the auditors, warned brokerage managers and company directors that they had no choice but to abide by a recently introduced accounting rule for valuing illiquid assets.

But even a well-resourced auditor can’t be expected to properly scrutinize the huge amount of level two and three assets sitting on banks’ balance sheets. For the seven banks Fortune surveyed, level three assets totaled over $430 billion, equivalent to 110% of the banks’ combined equity. That number will likely increase in the fourth quarter, making bank balance sheets even harder to read. Yes, that’s right: Wall Street’s black hole is getting bigger.

Update 11/12, 10:40 PM: I’ve lifted the following analysis from Bernard from the comments:

I think it puts things in clearer perspective if we look at the percentage writedown on Level 3 assets needed to eliminate all equity. This is just a different twist on the numbers already given.

If you look at it this way:

Morgan Stanley only needs to write down Level 3 assets by 39% to be wiped out.

Goldman Sachs 54%
Lehman Brothers 62.5%
Bear Stearns 64%

It is more accurate to look at tangible equity (which is equity minus intangible assets like goodwill). If the ratios are recalculated using that, then Citigroup’s ratio jumps up to 205% of equity.

Level 3 asset writedown needed to wipe out ALL tangible equity:

Citigroup 49%
Goldman Sachs 47%
Morgan Stanley 36%
Lehman Brothers 52%
Bear Stearns 64%

And yet this doesn’t even factor in the writedowns on Level 2 assets.

Now consider two other factors: as noted in the original post, Level 3 assets increased at all these firms in the third quarter. What if they go up again in the fourth quarter? We know one reason for Citi: they would up buying commercial paper of some CDOs they had sponsored to keep them from liquidating asset. Hung (or at least temporarily frozen) LBO financings were another factor. Cit may have more undisclosed contingent liabilities that come back to haunt them. The other player seem less at risk, but that’s no guarantee.

Moreover, a firm doesn’t need to lose all its equity to be in bad trouble. Mere serious losses will do. Counterparties may become reluctant to extend credit, and credit is the lifeblood of this business. Furthermore, the damage is often compounded by predatory trading. Traders who know a has to liquidate certain positions will sell into those positions, so that their competitor will be forced to sell at lower prices than he would otherwise achieve. Then the predator snap the securities back up on the cheap.