Goldman’s Proportion of Level 3 Assets Exceeds Merrill’s, Citi’s

Readers likely know that new accounting standards are forcing investment banks and other financial firms to specify how the value the assets on their balance sheet.

Level 1 assets are ones whose prices can be readily obtained (i.e., they trade actively); Leve 2 assets may not trade often, but they are very similar to assets that can be readily priced, so a Level 2 asset can be priced in relation to a similar (or several comparable) Level 1 instruments. Level 3 assets cannot be priced in relationship to actively traded assets. Many observers treat these values with considerable skepticism, calling them “mark to make believe.”

A Bloomberg story reports that Goldman’s ratio of Level 3 assets, at 6.9%, is higher than that of Merrill or Citigroup, both of which took well publicized writedowns (Note that an earlier Marketwatch story, citing Bernstein Research, had put Goldman’s percentage much higher, at 15%. It would be interesting to find out whether this was an error, or whether Goldman sold or reclassified former Level 3 assets). However, note that Morgan Stanley’s ratio was even higher, at 7.4%.

Goldman is also quite defensive about its Level 3 holdings, arguing they could be sold at the prices at which they are carried on the books. Sorry, but that argument doesn’t hold water. The very fact that these instruments can’t be priced in reference to a traded security means any valuation is guesswork.

From Bloommberg:

Goldman Sachs Group Inc. held a bigger proportion of hard-to-value assets at the end of the third quarter than Citigroup Inc. and Merrill Lynch & Co., two of the firms hardest hit by subprime mortgage losses.

Goldman’s Level 3 assets, for which market prices are so scarce that companies use internal models to gauge their value, accounted for 6.9 percent of the New York-based firm’s $1.05 trillion total at the end of August, according to a filing with the U.S. Securities and Exchange Commission. Citigroup classified 5.7 percent of its assets as Level 3 on Sept. 30 and Merrill reported 2.5 percent.

Investors have grown wary of banks and brokerages with difficult-to-sell securities on their books, after profits at Citigroup and Merrill were crippled by at least $19 billion of writedowns, mostly from bonds backed by home loans to borrowers with poor credit histories. While Goldman officials say the firm won’t report an “extraordinary” drop in its subprime holdings, investors have remained skeptical, pushing its shares down 15 percent this month in New York Stock Exchange trading.

“It’s hard to believe Goldman is perfect,” said Jon Fisher, who helps oversee $22 billion at Minneapolis-based Fifth Third Asset Management and sold his Goldman, Merrill and Morgan Stanley shares in the past 12 months. “Their losses might be smaller than others, but that doesn’t mean they don’t have a problem.”

Goldman posted a 79 percent increase in third-quarter profit, the biggest on Wall Street, even after shaving $1.48 billion from the value of high-yield loans….

“Just because they’re in Level 3 doesn’t mean we’re not pricing them correctly,” Goldman Chief Accounting Officer Sarah Smith said in a Nov. 9 interview. “We mark our positions to the point where we could exit at that moment.”

The 33 percent increase in Level 3 assets in the third quarter was mostly due to the freeze in the leveraged buyout market, which left firms including Goldman stuck with loans, Smith said. Goldman wrote down the value of those commitments when the debt was moved to Level 3. As the buyout market recovers, the loans may be upgraded to Level 2, she said.

Goldman’s Level 3 holdings totaled about $72 billion at the end of August. Stripping out stakes owned by others, Goldman’s “exposure” was $50.9 billion, or 4.9 percent of the firm’s total assets. A “substantial percentage” are private equity and real estate investments, said Goldman spokesman Lucas van Praag.

While those typically fall into the Level 3 category, assets such as leveraged loan commitments shift from one level to another depending on market conditions, Smith said.

“We take issue with the notion that all assets in Level 3 are hard to value,” said van Praag. “Given the disclosure rules, it is inevitable that any firm with a large private equity and real estate portfolio would have significant Level 3 assets.”….

“The market does not exist for a lot of these things,” said Edward Ketz, an associate professor of accounting at Pennsylvania State University in University Park, Pennsylvania. “Third level measures are fraught with lots of measurement error, in part because you are using assumptions.”….

“Even Level 2 is hard to price,” said Roger Lister, chief credit officer for financial institutions at Dominion Bond Rating Service. “Writedowns are coming out of Level 2 as well as 3. In the world of fixed income, prices have become less observable in the last few months. That’s why Level 3 is surging.”

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  1. Bernard

    The Bernstein Research numbers are different because they show Level 3 assets % of trading inventory (rather than total assets).

  2. Yves Smith


    Ah, thanks for the clarification.

    That of course makes the wounded complaints by the Goldman spokesmen “Gee this disparagement of our Level 3 assets isn’t fair, we have a lot of private equity and real estate investments” seem spurious.

  3. Anonymous

    The assets (Bonds) classification differentiates those which are hold for trading purpose and those for long term investments.
    The confusion is well entertained with the level 3 « no market price and naturally hold for short term trading« .

  4. paul

    GS is…special. Their level of cross-pollination with government makes them especially dangerous. If they go down, we’re in for a very, very long cycle of pain.

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