What are Level 3 assets?

The Financial Accounting Standards Board (FASB) recently issued the FAS 157 standard which is being implemented starting on November 15th. This standard requires that firms divide their assets into three categories called Level 1, Level 2, and Level 3.

Level 1 means assets that can be marked-to-market, where an asset's worth is based on a real price. One example would be a liquid stock traded on an exchange.

Level 2 are assets which are marked-to-model, an estimate based on observable market inputs but no direct available quoted prices. The firm can get several bids to derive the price, or base the pricing assumptions on what similar assets have sold for recently.

Level 3 values are based on "unobservable" inputs reflecting companies' "own assumptions" about the way assets should be priced. In other words, Level 3 assets are based on effectively best guess, or in many situations what firms want to value these items for in order to improve the situation in the books.

The majority of derivative instruments carried on the books of brokerages are Level 3 assets. The recent credit crunch has revealed the greater part of these items to be toxic waste, not worth pennies on the dollar of the value that the firms have them listed for in their books. Pressure from shareholder and regulators coupled with the new FASB standard are driving large banks to come clean about the proper value of these assets.

Just how big are the Level 3 assets?

Many of the banks have far more Level 3 assets than they have capital. Some examples that have been talked about in recent articles are provided below:

Citigroup
Equity base: $128 billion
Level 3 assets: $134.8 billion
Level 3 to equity: 105%

Goldman Sachs
Equity base: $39 billion
Level 3 assets: $72 billion
Level 3 to equity ratio: 185%

Morgan Stanley
Equity base: $35 billion
Level 3 assets: $88 billion
Level 3 to equity ratio: 251%

Bear Stearns
Equity base: $13 billion
Level 3 assets: $20 billion
Level 3 to equity ratio: 154%

Lehman Brothers
Equity base: $22 billion
Level 3 assets: $35 billion
Level 3 to equity ratio: 159%

Merrill Lynch
Equity base: $42 billion
Level 3 assets: $35 billion
Level 3 to equity ratio: 38%


This discussion does not even touch on the problems with Level 2 assets; many of these have lost value and are distressed. The disconcerting situation with Level 3 alone makes it evident that there are still significant write-downs at these firms which must occur. Recent information points to an expectation of losses over $500 billion across the sector. Some banking entities may be in such poor shape that they topple or are forced to merge.

In some sense the situation is both a liquidity crisis as well as a confidence crisis. Banks agreed to create the Super-SIV fund to improve liquidity, but the effective traction on implementation has been slow. Confidence further erodes with the continuing stream of bad news, and is not likely to improve over the upcoming month as banks reveal further losses. All of this leads to the likely situation of the credit crunch continuing for the forseeable future and having a broader economic impact.


Reference:
FASB - Summary of Statement 157
http://www.fasb.org/st/summary/stsum157.shtml

FASB FAS 157 - Fair Value Measurements
http://www.fasb.org/pdf/fas157.pdf