Filed under: Earnings reports, SEC filings, Market matters, Money and Finance Today

Recent bank earnings reports suggest that the costs of uncertain values of Level 3 assets — those hard-to-value financial instruments with no active trading market — could sink our financial system. By my estimates, the eight largest banks had a total of $517 billion in level 3 assets at the end of 2007, up 13% from the third quarter. And these assets represented 91% of those bank’s capital at the end of 2007, a rise from their 78% share of capital in the third quarter.

Why does this matter? First, because banks are taking big write-offs of these level 3 assets. Bloomberg News reported that Investors are wary of banks and brokerages with difficult-to-sell securities on their books as $232 billion of write-downs and credit losses from the collapse of the subprime mortgage market have crippled earnings. And Bloomberg points out that more assets have become difficult to value in the last three months as investors shunned a wider array of credit, reducing trading.

Secondly, the way these assets are valued is almost totally at the discretion of management. According to a Wall Street analyst I interviewed who covers the banking industry, many of the assets are very unique and each company really does appear to develop its own methodologies accordingly. The analyst asked a senior auditor at one of the big accounting firms whether they tried to impose any sort of conformity on the valuation processes used by companies they audit and the answer was no, even when one auditor handles several directly comparable firms.

The analyst continued, “And there is clearly no attempt among the auditors to get together to develop standards to be applied across all financial companies. So while I am sure the companies do make an honest attempt to do things that are intellectually supportable, in case the Fed or the SEC decide to drill down, the fact is that two different firms could value the same asset completely differently.”

This means that the biggest banks on Wall Street are resting on a sliver of capital that could be wiped out if they were forced to apply a common standard of how to value their bloated level 3 holdings. It amazes me that anyone would want to invest in a black box whose value is so hard to pin down.

Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter .

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This entry was posted on Friday, May 2nd, 2008 at 3:15 am and is filed under Money and Finance News. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.