So far, the very top tier of investment banking -- Goldman Sachs Group (NYSE: GS) and Morgan Stanley (NYSE: MS) -- have been relatively unscathed by asset write-downs. But that could change because both of these super blue chip banks have a huge exposure to Level 3 assets as a percentage of their total capital. If these firms end up taking big write-downs, their boards might start to ask questions about their CEOs too.
Level 3 assets are securities held on banks' books for which there is no market value -- they're marked to market. I calculated that seven leading banks have a total of $413 billion worth of Level 3 assets which exceed their total capital of $398 billion.
Level 3 assets are at the heart of the subprime mortgage meltdown. How so? These investment banks held onto subprime mortgage backed securities (MBSs) and collateralized debt obligations (CDOs). These so-called asset-backed securities are bundles of loans – e.g., credit card receivables, mortgages, auto loans, leveraged buyout loans.
They were – in many cases – given AAA ratings by Moody's (NYSE: MCO), McGraw-Hill Company (NYSE: MHP)'s S&P etc., which were paid by the investment banks that packaged the MBSs and CDOs. The banks that hold onto these assets don't have to write down their value unless the ratings get cut. In the last few months, the ratings agencies have cut the ratings on hundreds of these issues. Now there are no buyers for the securities and the absence of buyers means to me that the securities are worthless.
In the third quarter, nine Wall Street banks took $23 billion in asset write-downs reflecting the overstatement of these Level 3 assets. Uncertainty about how to value the Level 3 assets is responsible for uncertainty at all the banks, including Goldman Sachs. These write-downs were effective evidence in dismissing Merrill Lynch & Co. (NYSE: MER)'s Stanley O'Neal and Citigroup Inc. (NYSE: C)'s Chuck Prince.
Level 3 assets represent 251% of Morgan Stanley's capital and 185% of Goldman Sachs's capital – this could be a source of future trouble. Are these banks all using the same conservative methods for deciding which assets are Level 3? Are they all using similarly conservative methods to account for the value of these Level 3 assets?
Without answers to these questions, all bank boards have a huge information gap between what they need to know about the value of the Level 3 assets and what they currently know. And if it turns out that Level 3 assets at Morgan Stanley and Goldman Sachs need to be written down more, their CEOs could find themselves where O'Neal and Prince are now.
I hope, for their sake, that their Level 3 assets are in better shape than the ones at Merrill and Citigroup.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He owns Citigroup and has no financial interest in the other securities mentioned in this post.
Nuclear power is on the comeback trail
Apple backs AT&T in continuing spat with Verizon
Closing Bell: The recession is still over, still... do you feel it?
Reader Comments (Page 1 of 1)
11-07-2007 @ 11:03AM
steve said...
Nothing like trying to add more controversy and doubt to these securities. Many of these have been paying their dividends/interest with no problems for quite some time. Let's not blackball all. Might be a good time to start adding some of these to one's income producing sections of one's portfolio.
11-07-2007 @ 12:34PM
ALASTAIR said...
Are we looking at the not-too-distant demise of Goldman Sachs, Citigroup, Merrill Lynch, and maybe Morgan Stanley? If so, you would be best to hold on to that gold and those US Treasuries for a while. Because there is no financial institution out there prepared to merge with them or buyout any of them. Oh, may Petro China might try if they're stupid enough, but I don't think so.
11-12-2007 @ 2:05PM
Christiane said...
I too have learned a new vocabulary in the past year. Perhaps that is the reason that I find your points so disturbing. It is amazing to me that those in the upper levels of management seem such poor leaders and managers. Hopefully this is a wake up call to other CEOs et al. to ask more questions, probe more deeply, and actually do their jobs...lead!!! The shareholders rely on them to be good stewards. It is obvious that they are NOT!
11-16-2007 @ 9:48PM
lvngrld said...
The terminology is new to most of us because we never got to this level of problems. The market in the past never worried about how their returns were coming as long as there were returns. That's also part of the problem, that all should bear responsibility because the problem is larger than what we think and we cannot only blame the managers of these large institutions. I like also the creativity that we get 'liquidity puts'.... that's really creative.... let's check the legal terms of the contracts to see where this 'puts' were created as explained....