The Bear's Lair: Level 3 Decimation?
By Martin Hutchinson
October 29, 2007
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, 2005) -- details can be found on the Web site www.greatconservatives.com
There's a mystery on Wall Street. Merrill Lynch last week wrote off $8.4 billion in its subprime mortgage business, a figure revised up from $4.9 billion, yet Goldman Sachs reported an excellent quarter and didn't feel the need for any write-offs. The real secret of the difference is likely to be in the details of their accounting, and in particular in the murky world, shortly to be revealed, of their "Level 3" asset portfolios.
Both Merrill and Goldman have Harvard chairmen – Merrill's Stan O'Neal from Harvard Business School and Goldman's Lloyd Blankfein from Harvard College and Harvard Law School. Thus it's pretty unlikely their approaches to business are significantly different – or is a Harvard MBA really worth minus $8.4 billion compared with a law degree? (The special case of George W. Bush may be disregarded in answering that question!)
We may be about to find out. From November 15, we will have a new tool for figuring out how much toxic waste is in investment banks' balance sheets. The new accounting rule SFAS157 requires banks to divide their tradable assets into three "levels" according to how easy it is to get a market price for them. Level 1 assets have quoted prices in active markets. At the other extreme Level 3 assets have only unobservable inputs to measure value and are thus valued by reference to the banks' own models.
Goldman Sachs has disclosed its Level 3 assets, two quarters before it would be compelled to do so in the period ending February 29, 2008. Their total was $72 billion, which at first sight looks reasonable because it is only 8% of total assets. However the problem becomes more serious when you realize that $72 billion is twice Goldman's capital of $36 billion. In an extreme situation therefore, Goldman's entire existence rests on the value of its Level 3 assets.
The same presumably applies to other major investment banks – since they employ traders and risk managers with similar educations, operating in a similar culture, they probably have Level 3 assets of around twice capital. The former commercial banks Citigroup, J.P. Morgan Chase and Bank of America may have less since their culture is different; before 1999 those institutions were pure commercial banks and a substantial part of their business still lies in retail commercial banking, an area in which the investment banks are not represented and Level 3 assets are scarce.
There has been no rush to disclose Level 3 assets in advance of the first quarter in which it becomes compulsory, probably that ending in February or March 2008. Figures that have been disclosed show Lehman with $22 billion in Level 3 assets, 100% of capital, Bear Stearns with $20 billion, 155% of capital and J.P. Morgan Chase with about $60 billion, 50% of capital. However those figures are almost certainly low; the border between Level 2 and Level 3 is a fuzzy one and it is unquestionably in the interest of banks to classify as many of their assets as possible as Level 2, where analysts won't worry about them, rather than Level 3, where analyst concern is likely.
The reason analysts should worry is that not only are Level 3 assets subject to eccentric valuation by the institution holding them, but the ability to write up their value in good times and get paid bonuses based on their capital uplift brings a temptation that few on Wall Street appear capable of resisting. Both Goldman Sachs and Merrill Lynch are reported to have made profits of more than $1 billion on their holdings of Level 3 assets in the first half of 2007, for example, profits on which bonuses will no doubt be paid at the end of their fiscal years. Given that we have had five good years on Wall Street, years in which nobody has known the amount of Level 3 assets on banks' balance sheets, and no significant media waves have been made questioning their valuation methodologies, it would not be surprising if many banks' Level 3 assets had become seriously overstated, even without any downturn having occurred.
When Nomura Securities sold its mortgage portfolio and exited the US mortgage business in this quarter, it took a write-off of 28% of the portfolio's value, slightly above the 27% of the portfolio that was represented by subprime mortgage assets. Were Goldman Sachs's Level 3 assets similarly value-impaired, it would result in a $20 billion write-off, more than half Goldman's capital, leaving the bank severely damaged albeit probably still in existence.
Defenders of Goldman Sachs and the rest of Wall Street will insist that less than 27% of their level 3 assets are represented by subprime mortgages yet that is hardly the point. Subprime mortgages, estimated to cause losses of $400-500 billion to the market as a whole, though only a fraction of that to Wall Street, have been only the first of the Level 3 asset disasters to surface. There is huge potential for further losses among assets whose value has never been solidly based. These would include the following:
- Mortgages other than subprime mortgages. With the decline in house prices accelerating, the assumptions on which even prime mortgages were made are being exposed as fallacious. As house prices decline, debt to equity ratios increase, and for mortgages with an original loan-to-value ratio of 90% or more quickly pass the 100% at which a mortgage becomes uncovered. If the value of conventional mortgages decline many securities related to them, currently classed as Level 1 or 2 assets, will become un-marketable and descend into Level 3
- Securitized credit card obligations. $915 billion of credit card debt is currently outstanding, the majority of it securitized, and its default rate is likely to soar as the full effects of the home mortgage market's crack-up spread to the credit card area. The risks in Level 3 portfolios derived from this asset class arise particularly in the areas of complex derivatives and manufactured assets based on credit card debt pools.
- Leveraged buyout bridge loans. After a hiccup in August, the market in these has reopened recently, although around $250 billion of them still remains on banks' balance sheets. The value of a leveraged buyout bridge loan that has failed to find a pier to support the other end of the bridge is very dubious indeed, even though these loans are being carried in the books at or close to par. As the value of underlying assets declines and the cash flow fails to match debt payments, the deterioration in credit quality of these loans will accelerate.
- Asset backed commercial paper. The amount of asset backed commercial paper outstanding has dropped from $1.2 trillion to $900 billion in the last three months. This financing structure was always unsound; it was basically a means of removing the assets backing the commercial paper from bank balance sheets, and always faced the problem of a severe mismatch between asset and liability duration. The $100 billion vehicle intended to rescue this market has found a mixed reception to say the least. It is likely that as credit conditions deteriorate, the assets underlying ABCP vehicles will increasingly find themselves on bank balance sheets, where they will prove to be almost completely unmarketable.
- Complex derivatives contracts. Even simple interest rate swaps and currency swaps caused large losses in the last significant credit tightening in 1994, although most of those losses were suffered by Wall Street's customers rather than Wall Street itself. The more complex transactions that have been devised during the last twelve giddy years are much more likely to prove impossible either to sell or to hedge. Goldman Sachs reported that in the third quarter of 2007 its profits on derivatives used for hedging more or less matched its losses on subprime mortgages. It is likely in reality that the bulk of those profits were incurred through model-based write-ups of value on contracts that were within the Level 3 category – after all, Goldman's Level 3 assets increased by a third during the quarter. It's not much good shorting to match a long position you don't like if your hedging shorts prove to be impossible to close out.
- Credit Default Swaps, the global outstanding value of which in June 2007 was $2.4 trillion, according to the Bank for International Settlements. These are a relatively new instrument, the efficacy of which has not been tested in a downturn. It appears likely that the value in banks' books of their Level 3 credit derivatives contracts bears no relation whatever to reality. As discussed above, the incentives have been all in favor of inflating it.
The capital underlying Wall Street, at the top, is not all that large – a matter of a few hundred billion. Given the piling of risk upon risk that has been engaged in over the last few years, and the size of the losses in the mortgage market alone that seem probable – my own estimate last spring of $980 billion looks increasingly likely to be somewhat below the final figure – it appears almost inevitable that in a bear market in which liquidity dries up and investors become skeptical, Wall Street's capital will be wiped out. Only the commercial banks like Wachovia and Bank of America whose investment banking ambitions have been largely thwarted and portfolios of Level 3 rubbish are correspondingly lower are less likely to disappear.
Given the size of the overall figures involved and the excessive earnings that Wall Street's participants have enjoyed over the last decade, a taxpayer-funded bailout of Wall Street's titans would seem politically impossible, however loud the lobbyists scream for it.
In the long run, that is probably a blessing for the US and world economies.
http://prudentbear.com/index.php?option=com_content&view=article&id=4809&Itemid=53
Please Welcome SFAS 157—The New Fair Value Measurement Standard and Hierarchy
By Maria Nizza
Historically, there has been no single consistent framework within the accounting literature for applying fair value measurements and developing a reliable estimate of fair value. With authoritative guidance scattered throughout various accounting pronouncements, companies often found fair value estimates difficult to determine. Without a consistent framework applied to identical instruments, situations could arise whereby identical instruments held by different companies could have different fair value estimates.
Furthermore, the development of these fair value estimates is becoming more complicated since markets are continually issuing more complex and less liquid financial instruments. After numerous deliberations, the FASB has attempted to address this challenge by publishing Statement of Financial Accounting Standards No. 157, Fair Value Measurements, in September 2006 (the "Statement" or "SFAS 157").
http://www.pwc.com/Extweb/pwcpublications.nsf/docid/A955DCBCFC4C74048525721A005CB347/$File/fairvalue.pdf
Debugging Wall Street's funky math
Big chunks of investment banks' earnings are from assets that few know how to value. Should investors and regulators be concerned? Fortune's Peter Eavis puts on the green eyeshade.
By Peter Eavis, Fortune writer
September 7 2007: 5:47 PM EDT
NEW YORK (Wall Street) -- In the first half of the year, most Wall Street firms awarded themselves large profits from assets that are rarely traded and difficult to price, according to numbers contained in the brokerages' recent financial statements.
But, with markets seizing up since the end of June, those assets could be even harder to value, potentially prompting investors and regulators to question Wall Street's earnings.
Morgan Stanley (Charts, Fortune 500) andGoldman Sachs (Charts, Fortune 500) are scheduled to report their third quarter earnings over the next two weeks. At each firm, gains from assets and liabilities that rely heavily on subjective, in-house valuations were equivalent to 20% or more of pretax earnings, according to figures from documents filed with the Securities and Exchange Commission.
In its first half, Bear Stearns (Charts), which also reports earnings next week, appears to show losses of nearly $1 billion on these assets and liabilities, which are given the classification "level three" in financial statements, under an accounting regulation introduced at the end of last year by the Financial Accounting Standards Board. Lehman's level three gains were around 12% of pretax earnings in the first half.
Merrill Lynch (Charts, Fortune 500), Citigroup (Charts, Fortune 500) and JP Morgan Chase, which are scheduled to report third quarter earnings in October, made substantial earnings from level three assets and liabilities in the year's first half.
Brokerage houses do not break out net level three gains as a single number, so the level three figures are calculated using data contained in the banks' financial statements filed with the Securities and Exchange Commission (SEC).
Level three assets - which often include some types of mortgage-backed securities, as well as private equity investments - are the least liquid, but level two assets, which make up by far the majority of brokerage's financial assets, are also valued using arbitrary inputs because they don't trade in highly liquid markets. Only level one assets trade with dependable market prices, and they make up no more than a fourth of financial assets at most Wall Street firms.
This reliance on illiquid assets will only stoke fears that, during the credit boom of the last five years, the brokerages became too exposed to complex securities and financial instruments that will be worth less, and trade even more infrequently, in a more sober market environment. Referring to financial firms, Warren Buffett told Fortune last month, "They are marking to model rather than marking to market. The recent meltdown in much of the debt market, moreover, has transformed this process into marking to myth."
Homes entering foreclosure at record
It is also likely that the Securities and Exchange Commission and banking regulators are paying close attention to valuation of level three and level two assets at Wall Street firms. Their efforts to bring liquidity back to markets relies on the resumption of sound pricing in the markets and that will take longer if banks persist in overvaluing assets using their own potentially erroneous assumptions.
Most brokerages mentioned in this story declined to comment. When asked if Goldman was overly reliant on hard-to-value assets, spokesman Lucas van Praag said: "We don't agree. Our economic exposure to level 3 assets was $24.6 billion at the end of the second quarter and that needs to be seen in the context of a balance sheet of around $1 trillion."
Morgan Stanley spokesman Mark Lake noted that a large proportion of the firm's level three gains were from real estate, an asset that has real value, even though it doesn't carry regularly quoted prices.
In addition, some on Wall Street argue that the models used to value level 2 and 3 assets are more likely to be accurate than not, because Wall Street has learned from past meltdowns that it is a big mistake to misprice illiquid assets. In addition, Wall Street's supporters say it's misleading to compare gains from level three assets and liabilities with pretax earnings. Instead, they argue that a better approach is to compare them with revenues, because the level three gains aren't reduced by accompanying expenses that do get included in the pretax earnings calculation. However, if brokerages had been tweaking internal models to produce gains, the expense associated with that would not be high and a large proportion of the resulting profits would go straight to the bottom line.
In their SEC-registered disclosures, the brokerages acknowledge that caution must be used when handling level 3 gains and losses -- and argue that the level 3 assets and liabilities may be hedged with instruments that are classed level 1 or 2. For example, Lehman Brothers' quarterly earnings statement says: "Actual net revenues associated with Level III, inclusive of hedging activities, could differ materially."
Subprime: Let the finger-pointing begin!
In the first half, Morgan Stanley and Goldman Sachs showed level three net gains that were the highest in their peer group, as a percentage of pretax earnings. Morgan Stanley's $2.16 billion of estimated net gains was 28% of pretax earnings, while Goldman's estimated $1.95 billion amounted to 24% of pretax earnings in the first half.
Bear's apparent $1 billion losses from level 3 assets and liabilities raise two questions. First, do the losses suggest Bear is a sort of canary in a coalmine and is just earlier than its peers in showing level 3 losses? Or was Bear uniquely over-exposed to illiquid assets that turned toxic? Third quarter results from its rivals should help answer those questions.
To be sure, these numbers do not make an open-and-shut case that a sizable chunk of Wall Street's profits are made up out of thin air. Some of the big level three gains could be on assets that are real and are actually increasing in value at the moment. For example, mortgage servicing rights, which represent future cash payments by mortgage holders to their servicers, will be worth more at a time when borrowers are doing much less mortgage prepayments -- like now.
However, few would deny that Wall Street held too many assets that are now extremely illiquid and are worth much less than they were even six months ago. Many of these assets never traded in active markets, so even honest models will be struggling to come up with dependable values. There remains a cloud over the brokerage industry so long as it continues to rely on opaque models rather than real money.
Editor's note: An earlier version of this story used different figures for some banks' level three earnings that were derived using an incorrect methodology. CNNMoney regrets the error.
http://money.cnn.com/2007/09/06/magazines/fortune/eavis_level3.fortune/index.htm
http://www.beeland.com/ Jim Rogers Articles
http://www.rogersrawmaterials.com/
The Rogers International Commodity Index® (the "RICI") is a composite, U.S. dollar-based, total return index created by James Beeland Rogers, Jr. ("Rogers") on July 31, 1998. The RICI® was designed to meet the need for consistent investing in a broad based international vehicle; it represents the value of a basket of commodities consumed in the global economy, ranging from agricultural to energy to metal products. The value of this basket is tracked via futures contracts on 36 different exchange-traded physical commodities, quoted in four currencies, listed on eleven exchanges in five countries.
http://en.wikipedia.org/wiki/Credit_default_swap
A credit default swap (CDS) is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. Under a credit default swap agreement, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement).
Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge against credit events. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can be used to speculate on changes in credit spread.
Credit default swaps are the most widely traded credit derivative product[1]. The typical term of a credit default swap contract is five years, although being an over-the-counter derivative, credit default swaps of almost any maturity can be traded.
