Level 3 Assets – Part II

Below is the second post on level 3 assets. After you read both posts it may appear to you that the line between level 2 and level 3 is a little blurry. Text in bold is my emphasis. From Bloomberg:

Goldman Sachs Group Inc. held a bigger proportion of hard-to-value assets at the end of the third quarter than Citigroup Inc. and Merrill Lynch & Co., two of the firms hardest hit by subprime mortgage losses.

Goldman's Level 3 assets, for which market prices are so scarce that companies use internal models to gauge their value, accounted for 6.9 percent of the New York-based firm's $1.05 trillion total at the end of August, according to a filing with the U.S. Securities and Exchange Commission. Citigroup classified 5.7 percent of its assets as Level 3 on Sept. 30 and Merrill reported 2.5 percent. . . . .

. . . . ``It's hard to believe Goldman is perfect,'' said Jon Fisher, who helps oversee $22 billion at Minneapolis-based Fifth Third Asset Management and sold his Goldman, Merrill and Morgan Stanley shares in the past 12 months. ``Their losses might be smaller than others, but that doesn't mean they don't have a problem.''

``Just because they're in Level 3 doesn't mean we're not pricing them correctly,'' Goldman Chief Accounting Officer Sarah Smith said in a Nov. 9 interview. ``We mark our positions to the point where we could exit at that moment.''

The 33 percent increase in Level 3 assets in the third quarter was mostly due to the freeze in the leveraged buyout market, which left firms including Goldman stuck with loans, Smith said. Goldman wrote down the value of those commitments when the debt was moved to Level 3. As the buyout market recovers, the loans may be upgraded to Level 2, she said.

Goldman's Level 3 holdings totaled about $72 billion at the end of August. Stripping out stakes owned by others, Goldman's ``exposure'' was $50.9 billion, or 4.9 percent of the firm's total assets. A ``substantial percentage'' are private equity and real estate investments, said Goldman spokesman Lucas van Praag.

While those typically fall into the Level 3 category, assets such as leveraged loan commitments shift from one level to another depending on market conditions, Smith said.

``We take issue with the notion that all assets in Level 3 are hard to value,'' said van Praag. ``Given the disclosure rules, it is inevitable that any firm with a large private equity and real estate portfolio would have significant Level 3 assets.''

All the firms have adopted a Financial Accounting Standards Board rule, known as FAS 157, which requires public companies to disclose a breakdown of their asset valuations.

Under the rule, Level 1 assets are those for which market prices are readily available. Level 2 holdings are valued based on ``observable inputs,'' or prices of similar assets traded in the market. Assets fall into the Level 3 category when there aren't even any observable inputs, and the firm has to rely on in-house models to calculate potential gains or losses.

Morgan Stanley, whose Level 3 assets made up 7.4 percent of the firm's total at the end of the third quarter, said last week that it wrote down $3.7 billion in the first two months of the fourth quarter because of the declining subprime market.

Most of the writedowns were related to holdings of collateralized debt obligations based on subprime mortgage bonds. Goldman, like most firms, doesn't disclose the value of its CDOs, which are securities made up of other bonds and loans, including mortgages.

When Merrill announced its third-quarter writedown, the firm said its stake in CDOs fell by more than half to $15 billion. Citigroup reported last week that it had $43 billion of asset- backed CDOs. The company has said it may have to write down $11 billion on top of the $6 billion posted in the third quarter.

``The market does not exist for a lot of these things,'' said Edward Ketz, an associate professor of accounting at Pennsylvania State University in University Park, Pennsylvania. ``Third level measures are fraught with lots of measurement error, in part because you are using assumptions.''

``Even Level 2 is hard to price,'' said Roger Lister, chief credit officer for financial institutions at Dominion Bond Rating Service. ``Writedowns are coming out of Level 2 as well as 3. In the world of fixed income, prices have become less observable in the last few months. That's why Level 3 is surging.''