And he to me: “Thy city, which is full
Of envy so that now the sack runs over,
Held me within it in the life serene.
You citizens were wont to call me Ciacco;
For the pernicious sin of gluttony
I, as thou seest, am battered by this rain.
And I, sad soul, am not the only one,
For all these suffer the like penalty
For the like sin;” and word no more spake he.
Canto VI, the Inferno, the Divine Comedy
In the third of circle of Hell are the gluttonous. Drenched by a steady, miserable rain, their torments are lorded over by Cerberus, the three-headed hell hound. More on level three hell in a moment.
First, a lot of people are going to get fired at Citibank (NYSE:C). Some people will probably go to jail as well, as regulators investigate whether banks knowingly and improperly valued thinly traded assets. Under an American accounting rule that goes into effect on November 15th, banks will be forced to rate their assets according to how liquid they are. Assets at “level three” are the most illiquid.
Up to now, banks have been happy to chuck anything they couldn’t sell or trade in “level three”. The advantage of that is they can value the asset however they’d like, especially when it probably doesn’t have a market price since no one wants to buy it.
In other words, “level three” assets are the equivalent of a junk drawer in your kitchen. Or, they are that closet packed not with skeletons, but slowly decomposing corpses. If you want to know where the subprime bodies are buried, take the lift down to level three.
To make a long horror story short, many major Wall Street firms have level three assets that exceed their equity base. On Nouriel Roubini’s blog, he presents a level thee assets as a percentage of the equity for some notable firms. It is the kind of picture that might cause you to lose sleep at night.
Citigroup (of the US$11 billion in losses) has an equity base of US$128 billion and level three assets of US$134.8 billion. Its level three to equity ratio: 105%. Goldman Sachs (NYSE:GS)? An equity base of US$39 billion, level three assets of US$72 billion for a level three to equity ratio of 185%.
But wait…there’s more.
Morgan Stanley has an equity base of US$35 billion and level three assets of US$88 billion for a level three to equity ratio of 251%. Bear Stearns (NYSE:BSC), which got this whole credit party started, has an equity base of US$13 billion, level three assets of US$20 billion and a level three to equity ratio of 154%. Lehman Brothers (NYSE:LEH) has an equity base of US$22 billion, level three assets of US$35 billion and a level three to equity ratio of 159%.
In simpler terms, bank liabilities exceed capital. If those liabilities turn into losses, losses will exceed capital. And we all know what that means.
Of course it will probably not come to that. Or will it? Could banks face wholesale losses on all those level three assets? Even if they don’t, they will face some losses. And THAT will have real world ramifications.
The banks will have to shore up capital to match the real liabilities they face. They can also lobby Congress to delay the implementation of the new rule. But failing that kind of bribe, how does a bank shore up capital? It reduces leverage and debt. It takes losses. It sells other assets—if it can—to raise cash. Watch for all of these things.
Also, gold should do more than okay in this environment.
The Daily Reckoning Australia