By Dominic Elliott and Tom Fairless
Were it not for the credit crunch, reading the phrase "assets valued without observable market inputs" would be enough to glaze the eyes of most investors without advanced accountancy qualifications.
But in an uncertain climate of write-downs at investment banks, the term has drawn attention from analysts and shareholders.
International Financial Reporting Standards rules that applied from the start of last year require banks to break down their assets under fair-value accounting into three categories: those with market prices [Level 1]; those modeled on observable market prices [Level 2]; and those that banks are forced to value without any observable market data [Level 3].
The amount of assets on the balance sheets of Europe's largest banks in the third category, dubbed "mark to myth" or "mark to make-believe" by some analysts, almost tripled by the end of last year, according to Financial News analysis. ... The average ratio of opaque assets to total assets also rose to 3.8% last year from 1.8% at the end of 2006. Total assets under fair-value accounting for the five banks rose 23% to more than €4 trillion at the end of last year, as lenders were forced to bring more assets on their balance sheet under stricter capital-adequacy requirements and tougher market conditions.
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In part, the jump is a reflection of markets where trading has ground to a halt and caused price tags to disappear. "A lot of assets are now in no-man's land," said Christopher Wheeler, a senior research analyst at Bear Stearns.
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Assets modeled without reference to market prices can be of good or bad quality. However, the fact they are illiquid and difficult to value has fueled fears among some investors that they may lead to further write-downs.
The International Monetary Fund's Global Financial Stability Report, published last week, stated: "Market analysts may judge, correctly, that such a move reflects further illiquidity in the market or, incorrectly, that the firm's re-categorization of fair value methodologies represents a deliberate overestimation of the value that the assets would generate in a sale."
Matthew Clark, a European banks analyst at broker-dealer Keefe, Bruyette and Woods, said, "Some failed auction-rate certificates will be included in the bucket but, given the municipal underlying, are likely to be of sound asset quality and so not much of a concern. At the other end of the spectrum, subprime collateralized debt obligations will be complex to model and have much riskier underlyings -- these are a greater concern."
In the U.S., analysts have estimated that about 15% of Wall Street banks' so-called Level 3 assets, which are broadly comparable to those valued by European banks without observable market inputs, could be written down depending on the extent to which they are hedged.
Goldman Sachs Group Inc. increased its holdings of Level 3 assets by 39% during its fiscal first quarter ended in February to $96.4 billion, according to a regulatory filing with the U.S. Securities and Exchange Commission last week.
Goldman's ratio of Level 3 to total assets also rose, to 8.1% from 6.2%. Morgan Stanley's Level 3 assets rose 6.1% to $78.2 billion in the three months to February, while Lehman Brothers Holdings Inc.'s rose 1.3% to $42.5 billion for the same fiscal period. U.S. banks are required to reveal Level 3 assets under Generally Accepted Accounting Principles, while banks outside the U.S. follow their own jurisdictions or use International Financial Reporting Standards.
"Assets that are tough to value could or could not be problematic. That uncertainty is in itself problematic," said Mamoun Tazi, an analyst at MF Global Securities.
Banks may also have different ways of valuing such assets, making it harder for investors to compare rivals in the same sector.
A report published last month by independent research provider CreditSights showed European banks' valuations of their CDO holdings vary more than previously thought. This is partly because different regulators across Europe offer banks leeway in pricing assets under fair-value accounting.
"Consistency in accounting across the banking sector, auditors and countries is essential," said Leigh Goodwin, an analyst at consultants Fox-Pitt, Kelton.
European Commission accounting advisers this month added their voices to calls from bankers and insurers for fair-value accounting to be changed in order to prevent write-downs, as liquidations of assets lower market prices and cause banks to suffer more losses.
Last week the International Monetary Fund said, "Weaknesses in the implementation of fair-value accounting results should be addressed." It added that in a recession, banks could be required to make further write-downs while increasing capital reserves.
However, Mr. Goodwin said the additional insight into banks' asset structures under fair-value accounting is good for investors. "It would be terrible if fair-value accounting was abandoned," Mr. Goodwin said. "In tough market conditions, investors need to have as much information as possible.
"This is the time when we need mark-to-market information and as much disclosure as possible" he continued. "If banks were allowed to fudge asset values and not reflect market reality this may boost accounting profits and capital ratios, but it could backfire as investors, the interbank market, credit-rating agencies and perhaps regulators lost trust in the banks' figures."
Sabaziotatos says:
Once again we hear the argument: "We must not abandon mark-to-market accounting since we need its transparency now more than ever." This argument would make sense if mark-to-market accounting ensured transparency. It does not. The critique being leveled at mark-to-market accounting now is precisely that it introduces price distortion into the markets because of its pro-cyclicality. Advocates must stop boldly asserting that mark-to-market accounting ensures transparency, and instead try to demonstrate that it is not not pro-cyclical. For, if it is pro-cyclical, it must be abandoned or at least modified.
As for the movement of assets from Levels 1 or 2 into Level 3 when observable inputs disappear, this treatment is consistent with the guidance the SEC gave in its Sample Letter Sent to Public Companies on MD&A Disclosure Regarding the Application of SFAS 157 (Fair Value Measurements)
- "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. Only when actual market prices, or relevant observable inputs, are not available is it appropriate for you to use unobservable inputs which reflect your assumptions of what market participants would use in pricing the asset or liability. Current market conditions may require you to use valuation models that require significant unobservable inputs for some of your assets and liabilities. As a consequence, as of January 1, 2008, you will classify these assets and liabilities as Level 3 measurements under SFAS 157." [emphasis added]
- JPM CFO Michael Cavanagh: "And last comment, a little bit of increase - from 5% to 6% would be my estimate - in terms of Level 3 assets for the firm for the quarter, so not something that gives me any pause."
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