Monday, June 2, 2008

Level 3 Pricing

An accounting rule, SFAS 157, now forces companies to divvy their financial assets carried at market values into one of three buckets. Level 1 is for assets whose price is easily available; say, exchange-traded stocks. Level 3 is for assets that have "no observable price." Level 2 assets fall somewhere in the middle.

Level 3 assets may be difficult to price, but that doesn't mean they're always the right gauge of corporate health.

Isn't an increase in hard-to-price assets bad? It's a problem when the market dries up for assets that were previously easy to sell, meaning they become more illiquid, or harder to unload. It's an even bigger problem if Wall Street firms only intended to own those assets for a short period. And it's a really big problem if that causes banks to report losses.

But investment banks want to hold some illiquid assets, say, private-equity or real-estate investments, for long periods. They may also seek to profit from illiquidity: Goldman Sachs Group bought $6 billion of ailing mortgages last year, hoping to make a killing if markets recover. Although those went straight into the illiquid bucket, the corresponding increase in Goldman's Level 3 assets wasn't a sign of distress.

Aren't Level 3 assets priced using dodgy models? A lot of them aren't priced using models at all. Private-equity stakes are usually carried at the cost of investment with an allowance for what an exit price would be, unless something happens to change that, like a new round of funding at a different price. Real-estate investments are often valued using basic discounted-cash-flow models.

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