Billions in Level 2 Assets
A couple more articles, courtesy of Minyanville.
The other day I opined in Who Has More Level 3 Assets Than Capital? (posted below) that there were an exorbitant amount of Level 3 assets on the books of dealers and banks. I actually wouldn’t be surprised if the Federal Reserve has some after they took a load of stuff off the hands of their broker/dealer buddies.
My comments, frankly, were greeted by some cheers and some jeers. Either is OK by me, as my opinion remains the same. If there are no observable inputs to even mark your bonds to a model, good luck selling them. For example, I saw a huge, $50 billion bid list a few weeks ago out for the bid. How many traded? None.
Why? Because the bonds were marked at 35 and bids came in at 25. So this Structured Investment Vehicle (SIV) that was being told to sell couldn’t see, because if they had, the result would have been a negative equity situation. I’ve been trading mortgage backed securities for the better part of 25 years and I had no clue what levels to place on the bonds.
The bigger issue, however, is the speed at which Level 2 assets are growing. Level 2 assets, according to Bloomberg, are:
“Assets that have quoted market prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model derived valuations in which all significant inputs and significant value drivers in active markets.”
This is otherwise known as “mark to model.”
Below I’ve ranked companies by their absolute level of Level 2 assets and by ratio to total shareholder equity. I realize I may sound overly cautious to some, but in this business, discretion is the better part of value. Also, as an absolute return investor, I have to pay attention to something I think could be a problem. Even if it never develops, all I’ve lost is opportunity, not capital.
Level 2 Assets Ranked by Dollar Amount
1) Citigroup (C) $1.15 trillion
2) J.P. Morgan (JPM) $1.09 trillion
3) Merrill Lynch (MER) $1.02 trillion
4) Back of America (BAC) $781 billion
5) Goldman Sachs (GS) $620 billion
6) Bear Stearns (BSC) $332 billion
7) Fannie Mae (FNM) $321 billion
8 ) Morgan Stanley (MS) $304 billion
9) Prudential (PRU) $276 billion
10) Lehman Brothers (LEH) $200 billion
Level 2 Assets Ranked by Ratio to Total Shareholder Equity:
1) Merrill Lynch 28x
2) Bear Stearns 28x
3) Goldman Sachs 12x
4) Prudential 12x
5) Amerprise Financial (AMP) 9x
6) Citigroup 9x
7) American Electric Power (AEP) 9x
8 ) Genworth Financial (GNW) 9x
9) Hartford Insurance (HIG) 9x
10) Lehman Brothers 9x
11) Suntrust (STI) 8.7x
12) J.P.Morgan 8.7x
13) Anadarko Petroleum (APC) 8.7x
14) Travelers (TRV) 8.5x
15) Loews (LTR) 8.5x
Should we be afraid of this? As I said in my forecast for 2008, I Don’t Know.
Lastly, what bothers me the most is that each quarter more assets get moved from Level 1 (mark to market) to Levels 2 and 3. This is not a good trend and keeps me cautious.
Who Has More Level 3 Assets Than Capital?
New accounting rules allow for trading assets to be divided into three levels. Level One assets are the most liquid assets and therefore the easiest to price. They make up less than a quarter of most firms’ assets.
Level Two assets make up the majority of firms’ assets but rely heavily on the firms’ assumptions about things such as interest rates because they are far less liquid than Level One assets; according to regulatory filings by the five largest U.S. brokers and largest money center banks, there are more than $4 trillion in Level Two assets on their balance sheets.
Finally, Level Three assets are the least liquid of the firms’ trading assets and therefore are valued using what are called “unobservable inputs.”
Level Three assets include real estate, mortgage-backed securities, private equity investments and possibly even “undertakings of great advantage, but nobody to know what they are” (cf. South Sea Bubble).
The three magic words that make an asset a Level 3 asset are “no observable inputs.” What this means is that not only are they hard to price, but nearly impossible to sell.
Recently there’s been such deterioration in all types of mortgages that more and more assets are finding their way into this category. Also, this is the first time insurance companies have made the list. I think the list will continue to grow.
Ten companies now have more Level 3 assets than capital. In order they are (as a % of total shareholder equity:
1) Bear Stearns (BSC): 313.97%
2) Morgan Stanley (MS): 234.88%
3) Merrill Lynch (MER): 225.4%
4) Goldman Sachs (GS): 191.56%
5) Lehman (LEH): 171.18%
6) Fannie Mae (FNM): 161.48%
7) Northwest Air (NWA): 142.02%
8 ) Citigroup (C): 125.06%
9) Prudential (PRU): 119.36%
10) Hartford (HIG): 108.52%
So now we have insurance companies joining the party. Yes, the contagion is spreading and no, it’s not over. Not even close. C just had to pay 8.5% for $2 billion in preferreds. One of these days, there will be no takers.
For more on Level 3 assets, check out our series Now Approaching Level 3.
ilene9