A good measure of how closed many asset-backed, structured and other securities markets continue to be is provided by the new disclosures provided under FAS 157, Fair Value Measurement. Securities with little or no market activity fall into what’s known as “Level 3 inputs”–and under current conditions, that includes sectors such as private jumbo and Alt-A bonds, subprime paper, ABS CDOs and CLOs that in good times would have been considered as Level 2 assets. The big broker/dealers and banks were early adopters, and began recognizing write-downs and disclosing as prescribed by FAS 157 last year. Their third and fourth quarter filings were closely followed by a market just beginning to understand how deep an abyss had opened in the global capital markets. Now that the market has adjusted to the magnitude of Level 3 positions at the largest institutions, interest has shifted to the continued transition of assets into Level 3–but, bear in mind that some assets, such as private equity investments or exotic derivatives, will always belong in this category.

Some background on FAS 157: This newly-effective accounting standard defines fair-value as a market-based measurement. But it’s market-based, not mark-to-market. FAS 157 accounts for the fact that markets for some assets (and liabilities) measured at fair value under GAAP may be thin or inactive by creating 3 categories of measurement and disclosure. Level 1 fair values reflect quoted market prices for identical assets or liabilities, while Level 2 fair values are measured using market inputs such as prices for similar assets and directly observed pricing parameters such as interest rates, yield curves, volatilities, prepayments, and default rates. Level 3 fair values use the reporting entity’s own assumptions about the assumptions market participants would use to price the asset or liability (these assumed assumptions are the “unobservable inputs” that characterize Level 3.) In current MBS markets, a Level 1 asset is a TBA agency pass-through. A Level 2 asset might be an agency CMO (REMIC). These are priced against the swap or Treasury yield curve, using market conventions for prepayment assumptions and in reference to where similar bonds have traded. Trading is not brisk at present, but price points do exist for pricing standard structures like PACs and vanilla sequentials. Under current market conditions, the list of of Level 3 assets is painfully long and can include private jumbo and Alt-A bonds, subprime paper as well as other structured products such as ABS CDOs and CLOs (securitized leveraged loans).

For example, a UBS Mortgage Strategist report this week tracked the rising percentage in Level 3 assets from Q4 2007 to Q1 2008 at three large dealers. As of Q1 2008, Lehman reported $42.51 billion in Level 3 assets (5.4 percent of total assets), up 1.3 percent from the previous quarter. Morgan Stanley reported $78.16 billion (7.2 percent of total assets), up 6.1 percent from the previous quarter. Goldman reported two sets of figures for Level 3 assets –a total, and another excluding assets primarily owned by others. The first figure amounted to $96.39 billion (8.1 percent of total assets), up 39 percent; the second figure stood at $82.32 billion (6.9 percent of total assets), and up by 50 percent from the previous quarter. Pain for Newest Adopters Medium-sized and small financial institutions have begun to make the same disclosures (with related hits to capital) in their Q1 2008 filings, since the accounting standard became effective for fiscal years starting after November 15, 2007. The requirement has generated considerable consternation and “accounting denial” among many smaller institutions who struggled to believe that they would have to recognize impairment on securities they consider to be “money good.” One source, a middle market salesman at a major dealer, has been talking to me since early March about his bank customers’ struggles to come to grips with the new accounting reality created by FAS 157. The disbelief and misapprehension among smaller institutions were recently accentuated by an SEC letter sent out in early March to certain corporate treasurers. Given its timing so close to the deadline for adoption, the letter might have seemed like a routine reminder: “We note that you reported a significant amount of asset-backed securities, loans carried at fair value or the lower of cost or market, and derivative assets and liabilities” in recent financial statements, the letter read. In a nutshell, the SEC letter suggests that institutions measure and disclose those items as directed by FAS 157 in their upcoming reports. (The letter can be found here, for anyone curious.) While the letter goes on to make recommendations regarding disclosure of inputs and assumptions, particularly with regard to Level 3 assets, apparently some recipients took it as an implicit reminder to measure impairment and take write-downs. According to the same UBS report cited earlier, the brouhaha culminated in a letter from Sandler O’Neill to the SEC at the end of March asking the agency to “issue emergency interpretive guidance for determining fair value and assessing other-than-temporary impairment in the context of the extraordinary current market dislocation.” Recognizing other-than-temporary impairment is actually an application of the fair market valuation required by FAS 115, not FAS 157. Given that EITF 03-01 already provides guidance on this subject, the chances the SEC will issue additional guidance–emergency or not–are probably nil, but the request does give some measurement of the distress of institutions holding lots of illiquidity-damaged securities. (Under EITF 03-01, an investment is impaired if its fair value is less than its book cost. Impairment in debt securities is considered other-than-temporary unless the investor has the ability and intent to hold the security for a forecasted recovery of fair value up to, or beyond, its cost.) In their report, UBS expects the earnings season to continue to provide more write-downs, impairments, migrations of Level 2 into Level 3 assets, and capital raisings. Their focus–and surely the rest of the market’s as well–will be on firms’ Management and Analysis sections within their 10-Q filings for details of exposure. The Management and Analysis sections will also detail plans to contain risk. Noting the brilliance of Lehman’s strategy of securitizing a portion of its leveraged loan portfolio in order to access the discount window, UBS also expects to see other financial institutions adopt similar strategies for their distressed assets. Editor’s note: Linda Lowell is a mortgage market veteran, and principal of Offstreet Research LLC.

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