During the buildup to the Financial Crisis of 2009, leading investment banks were stocking their securities inventory with hard-to-value assets. These assets, because of the subjective way they are valued, became problematic when markets started to fall (because they fell the most). Assets generally have three tranches of valuation methodology and they range from Level I valuation, which is the safest, to Level III valuation, which is the riskiest.
The finance department of a major investment bank has the job of classifying their firm’s holdings into three categories so investors can handicap the risk associated of each asset held. U.S. accounting standards outline three distinct categories which tell a lot about an asset’s liquidity and associated risk. A Level I holding is an asset with a value based on a quoted price for an identical asset in the marketplace. An example of a Level I asset is a publicly traded stock or derivative. Level II holdings are assets with values based on a quoted price on an inactive market, or an asset with a value driven by a model with observable inputs. An example of a Level II asset could be restricted stock, corporate or municipal bonds, or various types of swaps (derivatives that trade off exchange). A Level III asset is the most esoteric and involves valuation techniques that require inputs that are both unobservable and essentially reflect management’s own assumptions about pricing. An example of a Level III asset is a private equity investment, commercial or residential mortgage, or long dated complex derivatives. As a rule of thumb, more Level I assets at a bank insure better liquidity and accurate values versus the subjective assumptions of Level III assets.
During the course of the past four years, Level III assets as a percentage of total bank equity have greatly improved, to the benefit of the shareholder. All four major banks in our research have drastically brought down the amount of Level III assets held, instead deferring to better quality assets including Level I and II assets. The most substantial decline has occurred at Morgan Stanley (MS) which at one point had over 137% of its total equity in risky Level III assets in the fourth quarter of 2009. Morgan’s current Level III assets sit at just 29% of total equity as of the most recent quarter. Citigroup (C), Goldman Sachs (GS), and Bank of America (BAC) have also moved their respective number of Level III assets held down which ensures a lower chance of substantial losses in these harder-to-value asset classes.
Level III assets are hard-to-value securities held by an investment bank for resale to other investors, or held to make a profit in principal trading. The substantial decline in these assets makes leading bank stocks much safer for investors.
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