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2 THE BEAR'S
LAIR Level 3 storm about to hit Wall
Street By Martin Hutchinson
There's a mystery on Wall Street. Merrill
Lynch wrote off $8.4 billion in its subprime
mortgage business, a figure revised up from $4.9
billion, yet Goldman Sachs reported an excellent
quarter and didn't feel the need for any
write-offs. The real secret of the difference is
likely to be in the details of their accounting,
and in particular in the murky world, shortly to
be revealed, of their "Level
3"
asset portfolios.
Both Merrill and Goldman
have Harvard chairmen - Merrill's Stan O'Neal from
Harvard Business School and Goldman's Lloyd
Blankfein from Harvard College and Harvard Law
School. Thus it's pretty unlikely their approaches
to business are significantly different - or is a
Harvard MBA really worth minus $8.4 billion
compared with a law degree? (The special case of
George W Bush may be disregarded in answering that
question.)
We may be about to find out.
From November 15, we will have a new tool for
figuring out how much toxic waste is in investment
banks' balance sheets. The new US accounting rule
SFAS157 requires banks to divide their tradable
assets into three "levels" according to how easy
it is to get a market price for them. Level 1
assets have quoted prices in active markets. At
the other extreme Level 3 assets have only
unobservable inputs to measure value and are thus
valued by reference to the banks' own models.
Goldman Sachs has disclosed its Level 3
assets, two quarters before it would be compelled
to do so in the period ending February 29, 2008.
Their total was $72 billion, which at first sight
looks reasonable because it is only 8% of total
assets. However the problem becomes more serious
when you realize that $72 billion is twice
Goldman's capital of $36 billion. In an extreme
situation therefore, Goldman's entire existence
rests on the value of its Level 3 assets.
The same presumably applies to other major
investment banks - since they employ traders and
risk managers with similar educations, operating
in a similar culture, they probably have Level 3
assets of around twice capital. Citigroup, J P
Morgan Chase and Bank of America may have less
since their culture is different; before 1999
those institutions were pure commercial banks and
a substantial part of their business still lies in
retail commercial banking, an area in which the
investment banks are not represented and Level 3
assets are scarce.
There has been no rush
to disclose Level 3 assets in advance of the first
quarter in which it becomes compulsory, probably
that ending in February or March 2008. Figures
that have been disclosed show Lehman with $22
billion in Level 3 assets, 100% of capital, Bear
Stearns with $20 billion, 155% of capital, and J P
Morgan Chase with about $60 billion, 50% of
capital. However those figures are almost
certainly low; the border between Level 2 and
Level 3 is a fuzzy one and it is unquestionably in
the interest of banks to classify as many of their
assets as possible as Level 2, where analysts
won't worry about them, rather than Level 3, where
analyst concern is likely.
The reason
analysts should worry is that not only are Level 3
assets subject to eccentric valuation by the
institution holding them, but the ability to write
up their value in good times and get paid bonuses
based on their capital uplift brings a temptation
that few on Wall Street appear capable of
resisting. Both Goldman Sachs and Merrill Lynch
are reported to have made profits of more than $1
billion on their holdings of Level 3 assets in the
first half of 2007, for example, profits on which
bonuses will no doubt be paid at the end of their
fiscal years. Given that we have had five good
years on Wall Street, years in which nobody has
known the amount of Level 3 assets on banks'
balance sheets, and no significant media waves
have been made questioning their valuation
methodologies, it would not be surprising if many
banks' Level 3 assets had become seriously
overstated, even without any downturn having
occurred.
When Nomura Securities sold its
mortgage portfolio and exited the US mortgage
business in this quarter, it took a write-off of
28% of the portfolio's value, slightly above the
27% of the portfolio that was represented by
subprime mortgage assets. Were Goldman Sachs's
Level 3 assets similarly value-impaired, it would
result in a $20 billion write-off, more than half
Goldman's capital, leaving the bank severely
damaged albeit probably still in existence.
Defenders of Goldman Sachs and the rest of
Wall Street will insist that less than 27% of
their Level 3 assets are represented by subprime
mortgages yet that is hardly the point. Subprime
mortgages, estimated to cause losses of $400-500
billion to the market as a whole, though only a
fraction of that to Wall Street, have been only
the first of the Level 3 asset disasters to
surface. There is huge potential for further
losses among assets whose value has never been
solidly based. These would include the following:
Mortgages other than subprime mortgages. With
the decline in house prices accelerating, the
assumptions on which even prime
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