Since the Financial Crisis, there has been a lot of buzz on how bank assets and liabilities are valued on their SEC filings. A few months ago I wrote an article, Fair Value Accounting is Alive and Well. This article details the exact specifics of SFAS 157, and how companies, specifically banks, value assets and liabilities on their balance sheets. I have decided to write a more bank specific piece that details Bank of America's (BAC) "fair value" assets, and how these assets (mainly Level 3) are valued.
Types of Assets
"Fairly Valued" assets (Trading Securities and Available For Sale Securities) are broken down into three classifications. As taken from my article that is linked to above these classifications are:
Level 1 (most desirable) - Uses quoted market price in active markets for identical assets (stock on an organized exchange).
Level 2 - Uses inputs that are observable for the asset such as quoted prices for similar assets or liabilities (pricing a commercial building using the price of a similar building across the street as a benchmark).
Level 3 (least desirable) - Uses unobservable inputs, that are based on the entity's own assumptions. (Used when valuing pension obligations, or securities whose markets are no longer active, orderly, or liquid).
I think it is fairly obvious at this point that it is the Level 3 assets that are causing all of the contention. In light of that fact, I am going to focus solely on Bank of America's Level 3 asset portfolio. Now, let's take a look at Bank of America's 10-K p.149, and see how they value these Level 3 assets.
Unobservable inputs that are supported by little or no market activity and that are significant to the overall fair value of the assets or liabilities. Level 3 assets and liabilities include financial instruments for which the determination of fair value requires significant management judgment or estimation. The fair value for such assets and liabilities is generally determined using pricing models, discounted cash flow methodologies or similar techniques that incorporate the assumptions a market participant would use in pricing the asset or liability. This category generally includes certain private equity investments and other principal investments, retained residual interests in securitizations, residential MSRs, asset-backed securities (NYSE:ABS), highly structured, complex or long-dated derivative contracts, certain LHFS, IRLCs and certain CDOs where independent pricing information cannot be obtained for a significant portion of the underlying assets.
Now, let's take a minute to digest this statement. Level 3 assets are valued using discounted cash flows, or pricing models. Plus, these valuations are only used when there is no orderly, active, or liquid market to accurately value these assets. Granted, these assets include CDOs, derivatives, ABS etc. securities whose very mention draws groans of disgusts, and shouts of anger from many individuals. But take a step back and think, if these assets are generating (or have the potential to generate) cash flow, should these assets be valued at zero (or less than there actual value to the company) just because there is no active or orderly market for them?
Breakdown of Bank of America's Level 3 Assets
The total amount of assets on Bank of America's balance sheet that are classified at Level 3 is equal to $64 billion dollars($16 billion of which are derivatives.) To put that into perspective the percentage of Level 3 assets to total assets ($2.22T) is 2.9%. A very small percentage of total assets. To give even more clarity, here is a breakdown of the Level 3 assets compared to total assets measured at fair value in their category (TS, AFS, Other):
- Trading Securities valued as Level 3 assets are 7% of total Trading Security assets,
- Available for Sale Securities valued as Level 3 assets are 4.2% of total Available for Sale Securities.
- Banks are given the option to measure certain assets at fair value (this is non-reversible.) The percentage of Level 3 assets to total Other Assets measured at fair value is 33%.
- The percentage of total Level 3 assets to all assets that are measured using fair value is 8.7% ($64 billion/$740 billion.)
When you look at the overall proportion of Level 3 assets to total assets, and total assets valued using fair value, claims of Bank of America's asset "overvaluation problem" and "opaque balance sheet" become extremely exaggerated. All data sourced from their most recent 10-Q.
Make Up And Dollar Amount of Level 3 Assets
|Security||Dollar Valuation (millions)||% of total Level 3 Assets|
|Non-U.S. Sovereign Debt||$375||.58%|
|Mortgage Trading Loans and ABS||$3,771||5.84%|
|MBS Agency - CMO||$55||.09|
|MBS Non-Agency Residential||$1,080||1.67%|
|MBS Non-Agency Commercial||$35||.05%|
|Other Taxable Securities||$9,342||14.46%|
|Loans and Leases||$5,300||8.2%|
|Mortgage Servicing Rights||$7,880||12.2%|
|Loans Held For Sale||$3,630||5.62%|
Only 33.69% of Level 3 assets are related to real-estate. Where are all of the real-estate related "toxic" assets that Bank of America values incorrectly? By my count, the only assets that are related to real-estate that might be incorrectly valued, amount to about $20 billion.
The case can be made that Level 3 assets are not valued appropriately, and I can understand why it would be made. But that argument falls on its face due to the fact that banks disclose how they value these assets, and which securities are valued using Level 3 inputs. Full disclosure of these facts discredits any kind of fraud allegations, and allows investors to make educated and informed decisions. Bank of America does not plan to keep these assets on the balance sheet as Level 3 forever. In fact, Bank of America has reduced its Level 3 assets by $4.3 billion Q/Q and $15 billion Y/Y. This is indicative of markets for these securities loosening up, and causing Bank of America to value these assets using observable inputs.
Disclosure: I am long BAC. I reserve the right to change any position at any time.