Much attention (and rightly so) is focused on SIVs, especially in relation to Citigroup (C). Too little attention however, is being paid to other problem areas that are also not being marked to market. I am referring to level 2 and level 3 assets.
Please consider the following headline Goldman:Aug level 3 asset value $72.05B, 7% of total.
Goldman Sachs Group Inc. (GS) said Wednesday the size of its level 3 assets at the end of third quarter increased to $72.05 billion from $54 billion at the end of the second quarter.
In terms of percentage, the New York-based investment bank’s third-quarter level 3 assets amounted to 7% of the total assets, compared with about 6% at the end of the second quarter.
Some firms began breaking down their financial assets into three levels at the start of their current fiscal year, which began in December, when they adopted early a new accounting standard related to fair, or market, value measurement. All U.S. companies will have to begin using it for financial years starting after Nov. 15.
Goldman Sachs said level 2 assets at the end of third quarter amounted to $494.6 billion. There may be some market activity for level 2 assets but the valuations often depend on internal models. Assets in level 1 trade in active markets with readily available prices.
In connection with its lending activities, the firm had outstanding commitments to extend credit of $135.53 billion as of August, compared with $100.48 billion at Nov. 30 fiscal yearend.
Goldman Sachs said loans and asset-backed securities exposure at August amounted to $55.3 billion, compared with $41 billion at Nov 30. The company said that for August, the exposure included $10.56 billion of loans that were transferred to securitization vehicles, where such transfers were accounted for as secured financings rather than sales.
Level 1, Level 2, Level 3 Assets
Inquiring minds just might be asking “What do those levels mean?”
Exact meanings can vary slightly but here are some descriptions from Merrill Lynch’s August 2007 10-Q.
[Mish comment: This category is commonly called “Marked to Market”]
Financial assets and liabilities whose values are based on unadjusted quoted prices for identical assets or liabilities in an active market (examples include active exchange-traded equity securities, listed derivatives, most U.S. Government and agency securities, and certain other sovereign government obligations).
[Mish comment: This category is commonly called “Marked to Matrix”]
Financial assets and liabilities whose values are based on quoted prices in markets that are not active or model inputs that are observable either directly or indirectly for substantially the full term of the asset or liability. Level 2 inputs include the following:
a) Quoted prices for similar assets or liabilities in active markets (for example, restricted stock);
b) Quoted prices for identical or similar assets or liabilities in non-active markets (examples include corporate and municipal bonds, which trade infrequently);
c) Pricing models whose inputs are observable for substantially the full term of the asset or liability (examples include most over-the-counter derivatives, including interest rate and currency swaps); and
d) Pricing models whose inputs are derived principally from or corroborated by observable market data through correlation or other means for substantially the full term of the asset or liability (examples include certain residential and commercial mortgage related assets, including loans, securities and derivatives).
[Mish comment: This category is commonly called “Marked to Model”]
Financial assets and liabilities whose values are based on prices or valuation techniques that require inputs that are both unobservable and significant to the overall fair value measurement. These inputs reflect management’s own assumptions about the assumptions a market participant would use in pricing the asset or liability (examples include certain private equity investments, certain residential and commercial mortgage related assets (including loans, securities and derivatives), and long-dated or complex derivatives including certain foreign exchange options and long dated options on gas and power).
Marked to Fantasy
All this focus on SIVs and conduits is actually leaving out a significant number or assets that are “Marked to Model”. For many corporations “Marked to Model” is likely to mean “Marked to Fantasy”.
Note the huge rise in “Marked to Model” assets at Goldman Sachs from to $72.05 billion from $54 billion. In addition Level 2 assets dwarf Level 1.
When it comes to real estate, especially REOs, it is doubtful we can trust level 2 valuations. For example, REOs would likely be valued on the basis of comparable appraisals. Who wants to trust those? REOs in the Bay area are up over 10-fold. Does anyone believe banks are valuing those properties correctly?
Tomorrow I will attempt to put together what’s at risk with SIVs, but that discussion leaves out “Marked to Fantasy”. It also leaves out “Marked to Matrix”. It also leaves out an impossible to sort out derivatives mess. I talked about derivatives in Genius Fails Again. Here is a short snip.
“Notional amounts of interest rate derivatives outstanding grew almost 14 percent to $285.7 trillion in the second half of 2006.” Look closely at that figure. Yes, that is trillion not billion. And that numbers was from 2006. It is higher today. Is it any wonder the Fed is spooked?
Estimates for the current notational amount of derivatives run anywhere from $300 trillion to $500 trillion. Given that accounting rules for banks differ from other corporations and differ still from offshore hedge funds, it is impossible to say what percentage of the combined picture is actually market to market, or how big the entire mess really is.
I am confident of one thing: The combined mess is simply too big to bail.
Mike Shedlock / Mish/