Level 3 Decimation?
October 29, 2007
Martin Hutchinson is the author of “Great Conservatives” (Academica Press, 2005) — details can be found on the Web site http://www.greatconservatives.com
There’s a mystery on Wall Street. Merrill Lynch last week wrote off $8.4 billion in its subprime mortgage business, a figure revised up from $4.9 billion, yet Goldman Sachs reported an excellent quarter and didn’t feel the need for any write-offs. The real secret of the difference is likely to be in the details of their accounting, and in particular in the murky world, shortly to be revealed, of their “Level 3” asset portfolios.
Both Merrill and Goldman have Harvard chairmen – Merrill’s Stan O’Neal from Harvard Business School and Goldman’s Lloyd Blankfein from Harvard College and Harvard Law School. Thus it’s pretty unlikely their approaches to business are significantly different – or is a Harvard MBA really worth minus $8.4 billion compared with a law degree? (The special case of George W. Bush may be disregarded in answering that question!)
We may be about to find out. From November 15, we will have a new tool for figuring out how much toxic waste is in investment banks’ balance sheets. The new accounting rule SFAS157 requires banks to divide their tradable assets into three “levels” according to how easy it is to get a market price for them. Level 1 assets have quoted prices in active markets. At the other extreme Level 3 assets have only unobservable inputs to measure value and are thus valued by reference to the banks’ own models.
Goldman Sachs has disclosed its Level 3 assets, two quarters before it would be compelled to do so in the period ending February 29, 2008. Their total was $72 billion, which at first sight looks reasonable because it is only 8% of total assets. However the problem becomes more serious when you realize that $72 billion is twice Goldman’s capital of $36 billion. In an extreme situation therefore, Goldman’s entire existence rests on the value of its Level 3 assets.