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
More Mr Mortgage
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