Banks say ‘trust us,’ and the level 3 geeks say maybe not

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One great thing about business crises is the way they turn so many of us semi-amateurs into temporary financial geeks. Five years ago it was all about stock-option accounting and special purpose vehicles. Now it’s collateralizalized debt obligations, special investment vehicles, and my personal favorite of the moment, “level 3 assets.”

These, sadly, don’t have anything to do with Level 3 Communications, the once-high-flying Internet-backbone operator. Instead, they’re the product of SFAS 157, a new rule approved by the Financial Accounting Standards Boards aimed at making companies’ estimates of the value of the securities on their books more consists. SFAS 157 establishes a “fair value hierarchy,” in which level 1 securities are those for which quoted market prices are available, level 2 are those for which there’s at least some kind of relevant market information, and level 3 for securities with, to quote from Citigroup’s 10-Q, “model derived valuations in which one or more significant inputs or significant value drivers are unobservable.”

So level 3 securities are those for which you get to essentially make up the value. And with faith that bankers will do so sensibly and conscientiously waning in the face of all the mortgage nonsense of the past year, level 3 holdings have become the alarm signal du jour. Goldman Sachs’ blowout earnings report in September has come under a lot of fire since for being so dependent on impossible-to-verify level 3 gains. And now Citi’s 10-Q, released yesterday, reveals that the company has a staggering $135 billion in level 3 securities.

That’s about as much as Regions Financial, one of the country’s 10 biggest banking companies (as well as the former home of my checking account and “the official bank of the Southeastern Conference“) has in total assets. It only amounts to 5.7% of Citigroup’s assets, though, while Goldman Sachs’s $72 million in level 3 stuff adds up to 7% of total assets (although Goldman says it “does not bear economic exposure” for $21 million of it, whatever that means, making its real Level 3 ratio 5%).

Who’s to say that’s the right ratio to look at, though? In a quintessentially Web 2.0 development Monday, a commenter on NYU economist Nouriel Roubini’s blog calculated level 3 assets as a percentage of shareholders’ equity at several big financial firms, and the numbers have been getting some attention today. Here’s what “Bernard” came up with (I doublechecked the Citi, Goldman and Merrill Lynch numbers and got pretty much the same percentages, so I’m going to assume the rest are right too):

Citigroup 105% [I got 106%, but whatever]

Goldman Sachs 185%

Morgan Stanley 251%

Bear Stearns 154%

Lehman Brothers 159%

Merrill Lynch 38%

I went and calculated JP Morgan Chase’s ratio, too (from the second quarter 10-Q; the third-quarter one will be out in a few days): It’s only 21%.

A company’s shareholder’s equity is its assets minus its liabilities–a.k.a. book value or net worth. So any firm with a ratio of level 3 assets of 100% or more is basically saying, Trust us, we actually are worth something. But we can’t prove it. This is to a certain extent always true of financial companies. But some of them have squandered an awful lot of trust lately.

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