Quantifying a WAG

Today several investment banks announced their share of Level 3 assets. In case you are wondering what level 3 assets are--and level 1 and 2 assets for that matter--the Wall St. Journal has this definition:

Level 1 is assets that have observable market prices. Think a stock traded on the NYSE.

Level 2 assets don’t have an observable price, but they have inputs that are based on them. Think an interest-rate swap where its components are observable data points like the price of a 10-year Treasury bond.

Level 3 is for assets where one or more of those inputs don’t have observable prices. This is the bucket that has been described as a guesstimate, because it is reliant on management estimates. As things stand now, companies who haven’t early adopted FAS 157 don’t give this more detailed breakdown to investors. So, one result of FAS 157 is more information.

Warren Buffet famously said that he never invests in things that he does not understand. I wonder how many investment banks truly understand what they have filed under Level 3 assets? (Bloomberg article)

Goldman's share of Level 3 assets surged 39 percent to $96.4 billion at the end of February from $69.2 billion in November, according to a filing with the U.S. Securities and Exchange Commission today. The ratio of Level 3 to total assets rose to 8.1 percent from 6.2 percent.

While many subprime-related stakes that lost almost 100 percent of their value since July were categorized in Level 3, other holdings such as private-equity stakes, real estate and rarely traded corporate debt are also included because market prices for them aren't available. More assets have become difficult to value in the last three months as investors shunned a wider array of credit, reducing trading.

Goldman Sachs has $96.4 billion of Level 3 exposure that is valued on what amounts to a wild ass guess (WAG). The obvious question is how can the figure $96.4bil be taken seriously if it is, by definition, a WAG?

Goldman Chief Financial Officer David Viniar said last month the Level 3-to-assets ratio had risen to about 8 percent mostly because some assets classified as Level 2, including commercial real estate loans, dropped to Level 3. The biggest increase in the hard-to-value category was a 59 percent jump in derivative contracts, according to today's filing. Mortgage and other asset-backed loans and securities increased 56 percent in the quarter.

Mr. Viniar does not seem too concerned that assets that were formerly able to be valued (Level 2) are dropping into the Level 3 bucket. This is the same Mr. Viniar that last August was shocked when their volatility models did not anticipate the severity of the sub-prime melt-down.

“We are seeing things that were 25-standard deviation events, several days in a row,” he said then.

My biggest problem with derivatives in general is that once you move beyond the realm of equity index options and futures, they seem to become easily decoupled from the underlying asset from which they are supposed to derive their worth. Many derivative markets, until recently, were several times more liquid than the market for the underlying asset, which is why a derivative was created in the first place. The problem then becomes once the music stops, the person left without a chair is stuck holding a bag that is impossible to value accurately. Once that person tries to value his "bag" it forces everybody else to do the same. And so the downward spiral of valuation begins; unless you can stuff it in the Level 3 sack. Eventually though, the can that keeps getting kicked down the road is going to get kicked back. I won't be surprised if it's loaded with gun powder and the fuse is lit.

To be sure, Goldman Sachs is not the only investment bank with this problem, just the biggest.

Morgan Stanley's Level 3 assets rose 6.1 percent to $78.2 billion last quarter, the firm said today in an SEC filing. Lehman, which also filed a report with the agency today, said its Level 3 holdings rose 1.3 percent to $42.5 billion. All three firms are based in New York. The harder-to-value securities made up 7.2 percent of Morgan Stanley's total assets at the end of February, up from 7 percent three months earlier. Lehman's ratio declined to 5.4 percent from 6.1 percent as total assets grew faster.Lehman CFO Erin Callan said last month the ratio would be around 5 percent.

Before we congratulate Lehman Brothers for a job well done, recall that they just raised $3bil a couple weeks ago to shore up their liquidity issues.

``The uncertainty of Level 3 asset valuation is already priced in the stocks of brokerage firms,'' said Steve Roukis, managing director at Matrix Asset Advisors Inc. which oversees $1.8 billion of assets in New York. ``We expect more writedowns in coming quarters, but they're not going to be huge numbers like the past quarters.''

I wish I was as optimistic as Mr. Rourkis, who believes that assets valued by WAGs are already priced into the market. However, I do not see this liquidity problem ending any time soon, which may be a contrary indicator...or not.