Level 3 Assets: What’s up with that and other Bugbear!

Level 3 assets have been bugging me big time. Basically, US FASB establishes how each bank “marketable” assets are valued.. For example Level 1 assets because there is a widely known market price; as an example you own shares of Research in Motion (RIM). Valuing the shares for balance sheet purpose should be simple, but its not; balance sheets are a “snapshot in time”, and have by definition several limitations; don’t even get me started on the tax implications. Assuming that the bank owns RIM shares; what’s the value of the shares, the average price paid, the price at the end of the year, or the average stock price during the year? The difficulty is easy to see, and each “value” can be justified. In fact, what is generally used in the US is the value of the shares at the end of the year…no better than either other methods but as long as everybody uses the same methodology.

Level 2 assets are more complicated, the best example are interest rate swaps, where two parties exchange the form of interest they pay (e.g. fixed rate Vs. floating rate). As an example a company borrows money based on a short term floating rate – because that’s what investors want, but the company wants some level of certainty, hence it wants a fixed rate. The valuation of a swap is based on a model; insofar as the are observations of interest rates (these can and do change), but at anyone point a bank can determine the value of the assets based on these curves. The bank didn’t ask for a price for the swap from other market participants, it used interest rate curves and futures price to determine the “value of the swap”.

Level 3 assets are the complicated ones; these are assets such as mortgage backed securities (MBS) where there is no real market for the assets, each security is different and complex, and historically the assets “value” of these assets have been determined purely by models. Part of the problem is that these models make some rather fundamental assumptions (which have proved very wrong) that can have a dramatic impact on the value of the assets, as an example in the past if the MBS was rated AAA by a credit agency the likelihood of loss was determined to be zero or close to zero (turns out these suckers were much riskier than . Part of the dilemma is that the real estate market has changed dramatically over the past few years…

In 2008, the U.S. authorities declared (via the FASB 157) that Level 3 assets were whatever the banks wanted them to be. So in August 2009 the Congressional Oversight Panel was told that the total amount of Level 3 assets held by the major US banks was USD 658 billion. Representing on average 5% of the banks’ total assets. Part of the problem is that for many of those banks these level 3 assets represented more than 80% of their market capitalization. As an example as of the end January 2010 JP Morgan’s total market capitalization is USD 158 billion, as of March 31^st, 2009 JPM’s total level 3 assets was USD 144 billion. JPM is today considered one of the US’s best financial institutions, moreover, it is widely know that in the case of JPM, their exposure to the MBS market was “minimal”. …

On the other hand Goldman Sachs was a major player in the market. As of March 31, 2009, as reported in its 8-K, Goldman Sachs’s level 3 assets amounted to USD 54 billion (at that time equal to 65% of it market cap), in the second quarter these level 3 assets apparently rose to USD 94 billion to fall back (as per the 8-k) to USD 46 billion. What is truly amazing is that in the space of 6 months USD 50 billion in GS assets moved from Level 3 to level 2 or were sold. This is a truly spectacular number, and it equal to 6% of GS’s total assets. On the bright side GS never tried to spin those numbers, in fact they go largely unmentioned, but it is truly amazing that over a period of 6 months GS saw a USD50 billion rise and fall of its level 3 assets. By the way, between march 31^st and September 30^th GS’ balance sheet shrank by USD 43 billion…

I’ve been looking for the notes regarding the “rise and fall” of Level 3 assets in other banks on the list, but so far no luck. I’ve not found any other bank mentioning a massive change in their asset clarification – in fact over the past 6 months GS’s balance sheet has remained relatively static (overall).

This morning I was enjoying my morning coffee and grapefruit with Ms. FitN when I can across the following article in the local French language paper

« Haïti: les orthopédistes veulent être payés »

Which translates to: Orthopedist surgeons who volunteered to go to Haiti want the Quebec Government to pay them their salary. My first reaction is: Are you fu%&ing kidding me! Now I grant these guys that out of the goodness of their own heart they volunteered their time to go and help the Haitians suffering from broken bones. It appears that their union (the doctors’) asked the government for the daily payment – because the payment in no way reduces the value of the volunteering efforts. Their comparison: Fireman – yep the guys who earn (by their own admission) CAN$ 6,000 per week (CAN$300,000 per annum) are comparing their situation to guys who earns CAN$ 70,000.

On second thoughts, I still think that “What the Fu$k applies”, its clear that getting paid $800 a day to work in Haiti is probably enough to cover their expenses, but so what. The whole point of volunteerism is just that you give of your time, not you give your time for partial pay.