Level 3 Asset Writedowns

Some market analysts are now expecting bank and brokerage writedowns to increase to between $100 and $500 billion, mostly due to the decline in value of Level 3 assets. Most of these writedowns will come as a result of a new FASB rule limiting the ability of companies to avoid valuing hard to value assets. According to the FASB terminology:

Level 1 means mark-to-market, where an asset's worth is based on a real price. Level 2 is mark-to- model, an estimate based on observable inputs and used when there aren't any quoted prices available. Level 3 values are based on ``unobservable'' inputs reflecting companies' ``own assumptions'' about the way assets would be priced.

Considering the sheer volume of Level 3 assets that most of the major US banks hold on their balance sheets and in off balance sheet entities, it seems shareholders would be very concerned about the degree to which banks can manipulate the value of those assets by changing their own assumptions. When banks finally reveal that those assets are truly as worthless as many of us assume, they will take even larger write-downs:

U.S. banks and brokers face as much as $100 billion of writedowns because of Level 3 accounting rules, in addition to the losses caused by the subprime credit slump, according to Royal Bank of Scotland Group Plc.

The Financial Accounting Standards Board's rule 157 will make it harder for companies to avoid putting market prices on securities considered hardest to value, known as Level 3 assets, Royal Bank's chief credit strategist Bob Janjuah in London wrote in a note today. The new rule is effective Nov. 15.

``This credit crisis, when all is out, will see $250 billion to $500 billion of losses,'' Janjuah said. ``The heat is on and it is inevitable that more players will have to revalue at least a decent portion'' of assets they currently value using ``mark- to-make believe.''

Wall Street's biggest firms have written down at least $40 billion as prices of mortgage-related assets dwindle because of record foreclosures. Morgan Stanley, the second-biggest U.S. securities firm, has 251 percent of its equity in Level 3 assets, making it the most vulnerable to writedowns, followed by Goldman Sachs Group Inc. at 185 percent, according to Janjuah.

The credit crunch is not over yet, and the worst may still be in front of us. If Wall Street is hurting this bad you have to imagine that we should see some more hedge fund blowups in the coming weeks. Hedge funds can hold off on valuing their assets longer, but eventually they will have to pay the piper.

Hat Tip: Bloomberg