America’s Mark-to-Model (Level 2) Banking System

Posted on October 9th, 2008 in Daily Mortgage/Housing News - The Real Story, Mr Mortgage's Personal Opinions/Research

Is $700bb really enough?  How insolvent are the nation’s leading banks?

Level 1, 2, and 3 assets are ways of classifying a company’s assets based on the degree of certainty around the assets’ underlying value. For example, Level 1 assets can be valued with certainty because they are liquid and have clear market prices. At the other end of the spectrum, Level 3 assets are illiquid and estimating their value requires inputs that are unobservable and reflect management assumptions. Think of it like Prime, Alt-A and subprime mortgage loans for example.

Somehow we have skipped right over Level 2 and are judging bank risk by looking at Level 3. Maybe in a robust credit market full of securitizations and leverage like 2006 this would have been just fine, but not now.  Perhaps this is unfolding in a linear way just like the mortgage crisis beginning with subprime (level 3), now onto Alt-A (level 2), then to Prime (Level 1).  Walls Street did a similar thing last year when it went right to focusing on CDO’s and forgot about all of the toxic whole loans and MBS on the balance sheet.

In the past several months, banks have been very focused on ‘selling assets and bringing down leverage’ with the primary focus being on their mostly toxic Level 3 ‘assets’.  That would be fine and dandy if their Level 2 ‘assets, which in this market may be equally as hard to value as Level 3, were not up to 20 times greater in Bank of America’s case for example.

The chart below show total Level 1, 2 and 3 ‘assets’. I have been keeping this for many quarters but shown is only Q2. However, if you look at level 2 assets/equity percentages it has been a road map to troubled banks with the exception of a few…but are those really exceptions.

**Note: This chart is a couple of months old numbers may have changed. My Excel is a little rough sometimes at times as well so you can visually look at row amounts vs total assets/equity in order to run your own ratios.

Level 2 ‘assets’ are by definition “Assets that aren’t actively traded, but have quoted market prices for similar instruments – otherwise known as ‘mark to model.'”  Could this be more mortgage debt?  We all know that all ‘modeling’ systems are broken and have been for years so how accurate are these marks, especially if much of this is mortgage debt. Look at the Wachovia line above. They have $160 billion in Level 2 assets.  That number is eerily similar to the amount of toxic Pay Option ARMs they hold.

The Level 2 numbers are so staggering that even a 7.5% haircut across the small group banks below would equal the total write downs by all banks worldwide to date!

Back on May 2nd I posted a story on Merrill playing ‘hide the CDO’ for reference and have updated my chart on 25 of the top financials and their Level 1, 2 and 3 exposure. What I found was astoundinig.  Of the 25 companies I studied, their total assets were $14.6 Trillion, Level 1 assets were a total of $1.3 Trillion, Level 3 assets were only $802 Billion but Level 2 Assets were $7.3 TRILLION!

Are you kidding me! 50% of the group’s total assets were Level 2 “assets that aren’t actively traded, but have quoted market prices for similar instruments – otherwise known as ‘mark to model.”

Wouldn’t it be great if the banks let you mark your investment portfolio to what you believed the assets to be worth on those dreaded days on which you receive a margin call?

All joking aside, this is an absolute disaster in the making. The Treasury does not have enough to take care of many of the nation’s largest banks.  The Fed does not either. As you can see they are OVER their heads in Level 2 and Level 3 ‘assets’, of which much has not been able to be priced for months. Much of it never will. -Best, Mr Mortgage

  • Level I: Mark to Market – readily observable market prices.
  • Level II: Assets that aren’t actively traded, but have quoted market prices for similar instruments – otherwise known as ‘mark to model.’
  • Level III: Assets that have model derived valuations in which one or more significant inputs or significant value drivers are unobservable-otherwise known as ‘mark to myth’ or ‘mark to management’s best guess,’ ‘mark to a hope & a prayer,’ etc…
  • More Mr Mortgage

    28 Responses to “America’s Mark-to-Model (Level 2) Banking System”

    1. Your work is astoundingly good! Is Faber getting this from you? He should have you on his show again. How do we contact him so that we can pursuade him that you need to be a regular? You deserve it! Would really give him credibility, but he’s getting better all the time.

    2. What is more, as the Level 2 and 3 assets come to light and their values are deflated, thereby destroying ever greater credit in the economy, the market value of the Level 1 assets is commensurately dragged down as well!

    3. Hi,

      This is a ticking time bomb. I think Former FED chief Volker called it “the mother of all crisis” Jim Sinclair calls them planet killers. Its all worthless in an unregulated market thats inot the trillions. There are $62 trillion in hte CDS category alone that Volker talks about. WHo and what planet has that kind of money. This supposedly clearinghouse is a joke. There are absolutes and always has been. Lehman’s portfolio is up on Friday. Let’s see how they explain this hocus pocus money scheme.

    4. National Debt Clock in Times Square Runs Out of Digits

      One word: REVOLUTION
      Take back our money, country and banks.

    5. sorry i’m dense, but it seems you are saying that all u s banks are, baring some literal miracle, in the same shape as iceland’s banks – i.e. bankrupt. that means the u s is in the same shape as iceland – i.e. bankrupt. except we don’t know it yet. disaster is none too strong a term – or am i misreading what you are saying?

    6. I think that’s what it looks like.

    7. Uh….so you saying the Dow could go below 8000?

      If the banks are broke, our gov’t is beyond broke,…WTF??

    8. What is your take on Schiff?


    9. Mr. Mortgage, I’ve got all of my cash at Wells Fargo – hit (leave) or stick (stay)? – trying to figure out if I should go spread the money around some (which will hurt since I am a Wells preferred PMA, etc. brokerage client, etc.) and if Wells will be a survivor – I am concerned about their Level 2 assets and that they have not taken the writedowns that are coming.

      I almost think that they are losing by getting Wachovia. The known is better than the unknown today.

    10. The Banks are BROKE. They have over $ 14.7 TRILLION in WORTHLESS debt. The US Treasury and the Fed DO NOT have the financial capacity to bail out the banks. All paper : CD’s,Money Market funds, corporate paper,Pension Plans, Insurance companies are buyers of this worthless debt which means they’re worthless also. There is an additional $60 TRILLION of CDS paper and over $ 500 TRILLION of derivatives (per the BIS – Bank of International Settlement ,Basel/Switzerland. The world economy generates only $60 TRILLION in economic activity. IN other words there is NO money to bail out any entity. The world is awash in MASSIVE debt and there is a financial depression /deflationary cycle coming which will wipe out every bank, government, individual. The end has begun!!!

    11. All joking aside, this is an absolute disaster in the making. The Treasury does not have enough to take care of many of the nation’s largest banks. The Fed does not either. As you can see they are OVER their heads in Level 2 and Level 3 ‘assets’, of which much has not been able to be priced for months.

    12. so to prepare for the banks all going broke
      any recommendations on where we should be investing
      our money ??

    13. The current financial system depends on most people NOT understanding how it works because it is a very fragile superstructure (and has been for decades). Once a majority of people get a handle on how unstable it really is the confidence goes away. This is happening now.

    14. Mr Mortgage — What does a negative number mean?

      Please check your formulas. For example, merrill level 2 is 936k, assets are 966k. That’s around 96%, not 2600%. And you cannot have negative numbers unless level 1 is negative.

    15. Mark,
      The comparison is between the different level assets and EQUITY (not total assets). And Merrill’s level 2 assets are 2591% more than what the total equity is.

      The negative numbers mean, that that level asset is below the equity. For example: a -11% means, that the assets are only 89% of the total equity. (+)11% means that that level asset is 111% of the equity.

      At least that’s how I read it. Someone please correct me, if I’m wrong.

    16. I went to buy a toaster yesterday and they gave me a free bank while I was there.

    17. Paulson’s new plan is to just buy the stupid banks. If they are broke and insolvent and we the people insure them through the FDIC then we might as well just buy the damn things and take ownership rights. Heck, there broke and where broke so it is a match made in heaven…

      What I don’t get is why does the Fed keep trying to inject liquidity when everyone is too broke to use it? We have a capital problem so short of handing people and businesses cash, all their attempts are failing miserably!!! We can’t take on any more debt and in fact that is the entire problem here… TOO MUCH debt!!! So the Fed keeps trying to jam more debt down everyone’s throats.

      My Cash Infusion Plan:

      Take the $700 Billion and give every voter that shows up on Election Day a coupon to a bank (Worth say $3,000.00). The coupon is not redeemable until say March 31’st 2009. The $700 Billion is then equally (to size) placed into savings accounts around the country. The banks have cash to use to start moving the needle back in the other direction and the consumer has money on the way. Every subsequent quarter you elect to choose not to cash in your coupon then you get an additional 25% of its value until you have reached 100% at which time you must take it. Banks can elect to work out a deal at that point where you roll it over into a CD or something.

      Now rip it apart people, but it just came to me over lunch and sounds pretty good right out of the gate doesn’t it? Obviously it needs some major work, but the thought of the principle of the idea is what I am asking for input on?

      Anyone else have a radical approach or idea out there?

    18. The coupons given out would have to match the votes made on Election Day for each region. The government then prints these coupons out and issues them to the banks for an amount equal to the amount of voters that came out for that region. The voters then go to the bank and get one half of the numbered coupon to hold until maturity. Each week the Fed adds up each coupon that was picked up by a voter and deposits the correct amount into a special account at the bank. No interest is paid on this money by the bank or the coupon holder. We would get voters to the polls I can tell you that and we would also get CAPITAL in the hands of the banks initially and the consumer afterwards which is the order in which it needs to happen. Also I would guess a solid 605 or more would choose no to take the coupon for quite sometime. I know I would wait out the year for a double take. ALL coupons are 100% guaranteed by the FDIC!!!

    19. You would get 1/3 of the numbered coupon at the voting station to match up with the one at the bank and Fed. They would write your name and SS # on it to match up with the voter registration paperwork and ultimately the banks to follow-up with a 3 way match to assure accountability…

      I don’t know how many Millions (? Voters x $? = $ Total Sum for Region / Sate / City or Town) this would place into banks and ultimately consumers pockets, but I feel it would do a heck of a lot more than a “Bail Out” bill for bad assets, plus we would get two benefits from the same money!!!

      The Amount of the coupons is not yet clear for their eventual worth, but we can figure that out by how many voters turn out pretty quickly ($700 Billion / Total Voters = Total Amount per coupon).

    20. A year ago, or maybe even further back then that, Marc Faber said there is a world wide real estate bubble. I’ve read that Spain has problems with falling real estate prices. What I wonder is: aren’t all banks in trouble in the developed world with unrealized losses in their mortgage debt assets?

      Has anyone come across an article covering this topic?

    21. Milt,
      I know that Germany has some major problems. My mother there is getting really worried.

    22. France, Spain, Iceland (obviously), Germany, Belgium, Netherlands, Italy,UK, and the USA, are all broke.

      It’s kind of Ironic how Iran is sitting pretty right now.

    23. Puts things in perspective. That 700 billion figure is going to have to go up times 5! To just recapitalize the banks and than to have them lending again is going to be something else.

    24. think iran may be feeling this with crude now at 75 bucks 😉

      for now i plan to stick with my accts in banks and bd’s….all now below fdic and spic limits.

      like art cashin sez….how do you price in the end of the world???

    25. Mr. Mortgage — Great stuff. A very useful extra column to add to your spreadsheet would be the liabilities (such as customer deposits) that each bank is liable for. That might give us a rough idea of assets versus liabilities.

    26. I really don’t understand what it means to say “the treasury doesn’t have the financial capacity to handle” this. The treasury can write a check for any amount of dollars it wants. There are no financial constraints. Anyone who thinks otherwise doesn’t really understand the system. Now, if you’re a banking system like Iceland (that owes a lot in foreign currencies), or the Euro countries (which don’t have currency sovereignity, and so can’t write the check either), it’s a different story, but its important to maintain the distinction.

    27. Nice chart.
      But I have a few questions: (Please forgive me for my stupid questions)
      It seems the assumption are that all the level 1,2,3 are all bad mortgage debt.

      What level does the banks commercial real estate assets fall into? How much of a banks assets are tied into commercial real estate?

      How about mortgages that aren’t toxic? Like those mortgage debt made before this whole bubble began? What level does that fall into?

      I’m not sure about how the numbers on this chart are supposed to be read. Could someone help clarify things a bit? Thanks!!

    28. I did a little more research.
      IMO this spread sheet cannot represent total residential real estate mortgage debt.

      You have to subtract commercial real estate, government bonds, cold hard cash, physical assets the bank owns (ie furniture,buildings…etc) … and maybe a few other categories before you can come up with the total dollar amount of residential real estate. And at that point I’d make the guess you’d still have to subtract the number of “good” debt, (ie non toxic mortgages) before arriving at the true dollar amount of all the bad toxic sludge that is out there.

      According to wikipedia the total mortgage loan and consumer debt was 11.4 trillion in 2005, how can it be then that roughly around 7.3 trillion of that is toxic sludge? OK, so maybe that number was an old number quoted back in 2005 but still… doesn’t seem to make much sense to me.

      Someone *please* stop me if I’m wrong.

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