Level 3 Assets Growing in All Five U.S. Investment Banks

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We didn’t have to get far in the headlines this morning to see the issue of just what capital really is come up. “The U.S. Securities and Exchange Commission will require investment banks to disclose their capital and liquidity levels after the agency was criticized for regulatory failings in the wake of the Bear Stearns collapse,” reports Jesse Westbrook at Bloomberg.

The SEC will require Wall Street firms to report on their capital and liquidity levels in, “terms the market can readily understand and digest.” Aha! So we will now know who has more dodgy assets than real capital. Of course, we already do know quite a bit.

A new accounting rule last November required banks to report their assets in three categories, from easiest to sell and value (Level 1) to hardest to sell and value (Level 3). We also know that all five major U.S. investment banks (Goldman, Merrill, Bear, Morgan Stanley, and Lehman) have level 3 assets that are at least double the capital listed on the balance sheet.

Write-downs in level 3 assets directly affect a bank’s capital. It might not seem like such a big deal at first. After all, at Merrill Lynch, Level 3 assets represent just 8% of the firm’s total assets. The trouble is that in the first quarter of this year, Merrill saw its Level three assets grow to US$82.4 billion-up 70% in just three months.

It’s not just Merrill, either. Goldman Sachs reported that its level 3 assets grew by 39% in the first quarter to over US$78 billion. Those assets are just 8.1% of the firm’s total assets. But again, they exceed by a large margin the firm’s capital base. The same is true of Lehman Brothers. And let us not mention that total liabilities for these firms are many, many times greater than stockholder’s equity.

In an unrelated development, shares for all five investment banks were down on Wall Street.

Seriously, with so many assets parked on level 3, with their ability to attract new capital infusions from foreign investors suspect, and with conditions in the American consumer economy so dire…what utterly oblivious investor would consider financial shares “good value”? When your assets are really liabilities waiting to be born, your capital hangs by a slender thread.

Australia probably has its fair share of balance sheet problems, both at the household and corporate level. We read in today’s Age, via professor Steve Keen, that “At the bottom of the 1990s recession…Australia’s debt was about 78 per cent of GDP. It is now 165 per cent. That’s more than doubled over the past 15 years. In 1892, he says, debt peaked at 104 per cent of GDP and in 1931 it peaked at 77 per cent.”

Buying assets with borrowed money is a dangerous game.

Dan Denning
The Daily Reckoning Australia

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.
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Comments

  1. Dan

    The key question is how many of the level 3 assets will actually default? Mogambo cites a Bloomberg which predicts up to a 16% default rate on US commercial paper. I really don’t know if things will get that bad but if they do, the banks along with investors be hit very very hard.

    In the Australian context most sythetic CDOs (Class 3 Assets) have exposure to firms directly impacted by the US sub prime crisis. For many instruments, this means partial or full capital loss if the default rate exceeds a certain level (usually between 7 – 11 %). In the case older, higher rated instuments, the banks issued capital protection to investors. This could represents a MASSIVE contingent liability, not be reflected adequately in the balance sheets of those banks.

    In a nutshell, more central bank funded bailouts of major banks are on the cards. Money will need to be printed to cover the costs.

    Coffee Addict
    May 9, 2008
    Reply

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