Which Financial Companies Are In Trouble

Who Has More Level 3 Assets and LOTS MORE Level 2 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, etc... The three magic words that make an asset a Level 3 asset are "no observable inputs." This means that they are very difficult to price, and sometimes also, very difficult to sell. Think ENRON and how they created assets that THEY got to price because there was no market to derive a market price for - well, maybe not that bad.

Recently there's been such deterioration in all types of mortgages that more and more assets are finding their way into this Level 3 category. Ten companies as of the end of Q1 2008 now have more Level 3 assets than capital. You can find them on the linked spreadsheet in order of the worst to the.... er, ah, .... not as worse (as a % of total shareholder equity).

I'm sure that you'll notice something strange in this list, too - the presence of a-traditional financial sector companies. There's insurance companies - maybe no great surprise, but an airline? Full Disclosure - I HATE Northwest Airlines - not as an investment in this case, but as an airline that has some crappy customer service.

Now, Level 2 assets are defined as: "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." Huh? This sounds like it might encompass a WIDE range of assets - from those that can actually be priced almost exactly to those that will be priced by with a little more accuracy than Level 3 Assets. These assets are growing quickly - that's what happens when entire securities markets disappear and there are capital allocation problems, such as now. Also on my spreadsheet, I have included columns on the prevalence and concentration of these Level 2 assets.

The introduction of FASB 157 on November 15, 2008 is fast approaching. The November 15th date isn't a drop dead reporting date, it's simply a date of implementation going forward regarding the recognition of fair value. Whether this "matters" remains to be seen. Many of these disclosures won't "hit" until next year although, according to a study from Deloitte, only six percent of companies (across a wide range of industries) have assessed how FASB 157 will impact the valuation of their assets and liabilities.

I think that before this time, it would be prudent for every investor to make sure they understand what their investments consist of. I'm not just talking about avoiding those companies that I detailed, but to re-examine your holdings and make sure that you don't end up with a real ugly surprise. Bear Stearns didn't need to wait until after FASB 157 to blow up. And from the looks of things, there are some companies VERY close to having a Balance Sheet that looks as bad as Bears (e.g., Merrill Lynch, Morgan Stanley with Goldman's and Lehman's not too far behind).

Did you also notice that J.P. Morgan was not in the top 10 list of Level 3 Assets? Maybe we now know exactly why J.P. Morgan was the entity "chosen" to acquire Bear.

Acknowledgment due Minyanville for the excellent analyses that I've basically combined and copied.