Banks are, if nothing else, entirely predictable. If there is a way to game the system, they will avail themselves of it.
Readers may recall that the Financial Standards Accounting Board implemented Statement 157, which required financial firms to identify how they arrived at the “fair value” for their assets. Level 1 are ones where there is a market price. Level 2 are those where there may not be much of a market, but they can nevertheless be priced in reference to similar assets that have a market price.
Then we have Level 3. They are priced using “unobservable inputs.” I have never understood this concept, because the use of sunspots, skirt lengths, the Mayan calendar, or a model using, say, a ratio of bullish versus bearish stories on Bloomberg would be an observable input. And fittingly, Level 3 is colloquially called “mark to make believe.”
And there are indeed signs that indicate that financial firms have playes fast and loose with this rule:
1. In the first quarter of 2007, Wells Fargo created $1.21 billion of Level 3 gains. Without them, it would have posted a loss.
2. Lehman added more assets to the Level 3 category at a time when better trading conditions said it should have been lowering them
However, it is now completely kosher to play games. While the three-level hierarchy became effective on January 1 of this year (some firms chose to comply early), the SEC largely gutted it in the wake of the Bear collapse. From its March press release:
Fair value assumes the exchange of assets or liabilities in orderly transactions. Under SFAS 157, it is appropriate for you to consider actual market prices, or observable inputs, even when the market is less liquid than historical market volumes, unless those prices are the result of a forced liquidation or distress sale (boldface ours).
We noted back then:
But now the SEC has given banks and brokers a huge out. No matter how small or easily absorbed by the market a forced sale might be (think of a hedge fund hit by a margin call), a financial institution can ignore the price realized. In fact, they get to determine what trades constitute a forced sale.
Fast forward to today. What do we see now? The financial services industry has a world-class bad quarter. So what does it do? increase the amount of assets it considers to be Level 3 so it can assign them more favorable prices.
And there is possibly a second reason for this move. Year end financials are audited. Accountants have been much less accommodating of late. Moving a lot of assets into the Level 3 bucket right before your auditor walks in might not pass the smell test (although once you have done that, they really cannot question how they are marked). Better to do it at least a quarter in advance.
From the Financial Times:
The biggest US financial institutions reported a sharp increase to $610bn in so-called hard-to-value assets during the third quarter, raising concerns about the hidden dangers on balance sheets.
So-called level-three assets, classified as hard to value and hard to sell, rose 15.5 per cent from the second quarter, according to analysis by the Market, Credit and Risk Strategies group of Standard & Poor’s.
Level-three assets have risen all year for most banks as they have found it virtually impossible to sell mortgage-backed securities and collateralised debt obligations.
“A lot of banks are saying: ‘I am going to move securities to level-three assets because I have more control over, and confidence in, the model used for their valuations’,” said Gregg Berman, head of the risk management unit at Risk Metrics.
The study is based on regulatory filings by the biggest underwriters and traders of mortgage-backed securities and CDOs. These asset classes have plunged in value amid a wave of house price falls and foreclosures and are at the centre of the crisis…
Michael Thompson, managing director of MCRS, said he would be “surprised if we did not see writedowns of these level-three assets” in the fourth quarter.
Already, level-three assets are many times bigger than the market cap of the banks.
Ahem, the whole point of this exercise is to take lower writedowns than you would have otherwise.