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What is a Level 3 Asset?

Other banks have been moving assets to Level 2 and Level 3 in order to put off the inevitable losses. The definition of these levels according to FAS 157 are as follows:

1. Level 1 Assets that have observable market prices.
2.  Level 2 Assets that don’t have an observable prices, but they have inputs that are based upon them.
3. Level 3 Assets where one or more of the inputs don’t have observable prices. Reliant on management estimates. Also known as mark to model.

This is Warren Buffet’s view on the financial institution practice of valuing subprime assets on the basis of a computer model rather than the free market price.

In one way, I’m sympathetic to the institutional reluctance to face the music. I’d give a lot to mark my weight to ‘model’ rather than to market.

So, the managements of the banks that loaned money to people who could never pay them back are now responsible for estimating what these assets are worth. According to Bill Fleckenstein,

Recently, the portfolio of Cheyne Finance, one of the more infamous structured-investment vehicles, or SIVs, was sold at 44 cents on the dollar. I suspect that similar assets are not marked anywhere near that valuation on financial institutions’ balance sheets. So, the game of “everything’s contained” continues, albeit in a different form.

Source: Company records

Merrill Lynch – Poster Child for Lack of Bank Credibility

John Thain is the Chairman and CEO of Merrill Lynch. He makes in excess of $50 million per year in compensation. He previously held positions as President, COO and CFO at Goldman Sachs. He is a good buddy of Hank Paulson. Here are a few recent quotes from Mr. Thain:

“…These transactions make certain that Merrill is well-capitalized.” (January 15, 2008 — Thain in a statement after selling $6.6 billion of preferred shares to a group that included Japanese and Kuwaiti investors)

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“…Today I can say that we will not need additional funds. These problems are behind us. We will not return to the market.” (March 8, 2008 — Thain in an interview with France’s Le Figaro newspaper)

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“We deliberately raised more capital than we lost last year … we believe that will allow us to not have to go back to the equity market in the foreseeable future.” (April 8, 2008 — Thain to reporters in Tokyo, as reported by Reuters)

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“Right now we believe that we are in a very comfortable spot in terms of our capital.” (July 17, 2008 — Thain on a conference call after posting Merrill’s second-quarter results)

Merrill Lynch reported a loss of $4.7 billion for the 2^nd quarter on July 17. On July 28, eleven days after this earnings report they announce a $5.7 billion write-down and the issuance of $8.5 billion of stock. Thain, the $50 million man, is either lying or completely clueless regarding the company he runs. The SEC needs to investigate him, rather than short-sellers. Their books are a fraud and anything their CEO says cannot be trusted.

Below is Barry Ritholtz’ assessment of the Merrill Lynch deal:

• Merrill appears to be moving $30.6 billion dollars of bad paper off of their books.
• This paper was carried at a value of $11.1, meaning there was almost $20B in prior   related write downs. 
• After this transaction, Merrill’s ABS CDO exposure in theory drops from $19.9 billion to $8.8 billion (hence, the $11.1B number). 
• The $6.7B purchase price relative to the $30.6B notational value is 21.8% on the dollar.
• Merrill is providing 75% of the financing –- and MER’s only recourse in the event of default is to retake the CDO paper back from the buyer.
• While Merrill hopes to be made whole, the reality is they still have potential exposure to these ABS CDOs via the financing; 
• Actual sale price = 5.47% on the dollar 

Less than five and half cents on the dollar? That’s an even cheaper sale than originally advertised. What this transaction actually accomplishes is getting the paper — but not the full liability — off of Merrill’s books. How very Enron-like!

Merrill Lynch has a market cap of $24 billion and has raised $30 billion since December just to keep making their payroll. How long will investors be duped into supporting this disaster? You can be sure that the other suspects (Citicorp (C), Lehman Brothers (LEH), Washington Mutual) will be announcing more write-downs and capital dilution in the coming weeks.

Is Housing Near the Bottom?

The one person who has been consistently right regarding the housing market is Yale Professor Robert Shiller. (He also called the top in the stock market in 2000).

The following chart clearly shows that home prices are so far out of line with historical averages that there is no doubt that further decreases are in store.

Home prices have historically tracked inflation and are likely to revert to the mean. The latest data from Case-Shiller does not paint a pretty picture. Sale prices of existing single family homes declined by 15.8% in the past year, with markets in California declining by 22% to 28%. Over 10% of the U.S. population lives in California. Bank of America (BAC), Wells Fargo, Washington Mutual, and Wachovia have a large exposure to California.