Big Brokers' Level 3 Assets: Not As Scary As People Say

Felix Salmon at Portfolio.com dug up the ratios for how many level 3 assets at each major Wall Street broker. This ratio is seen by some to be "scary". I don't find it as scary as some. The assets in Level 3 are mark-to-model. Some of these could include complex derivatives for which there is no market that exactly hedge assets for which there is no market. Hence the risk in a panic liquidation is high but there is little cash flow risk. There markets are worried about some of those with the highest ratios of Level 3 assets to capital. Personally, I trust the risk managers at firms like Goldman Sachs (GS) ($212.89), Morgan Stanley (MS) ($50.88) and Lehman Brother (LEH) ($63.03) to be able to correctly value these situations. I do believe the market will continue to focus on this ratio which will encourage firms to try to move more assets out of this category.

Disclosure: I own GS, MS and LEH. I am vested in the executive compensation plans, executive option and pension plans at Morgan Stanley and Lehman. I am a former managing director at Morgan Stanley and Lehman. I have traded (bought and sold) GS, MS and LEH in the past year.

Comments

[Pj568]

Its more than risk management. Its probably more dependent on having the proper financial structure in place. Level 3's don't have a liquid cash market and require greater transaction costs and longer time periods to achieve a nondistressed sale. Those with anticipated liquidity problems will be the ones experiencing the greater losses rather than those with the ability to hold indefinitely.

[Anonymous 2]

Obviously absent from the comments were the "other two" of the big 5 stock brokerage firms.
It would be interesting to learn of views by analysts about what the current market is "expecting" or "discounting"... in terms of what will (levels) be disclosed by BSC and MS this coming week... I.E., what will be the Level 3 disclosed by each and to what extent will it have been increased - or decreased - since the most recent disclosed level? And in each case - except for GS, and perhaps LEH - what is the perceived or actual status of the most senior levels of management responsible
to the company's employees for providing a well diversified portfolio of products and
to the company's retail and institutional investor clients an appropriate level of prudent risk management and
to the shareholders a "proper financial structure in place" (mentioned above) along with an appropriate long term diversified and strategic growth plan to remain viable and profitable in volatile market environments.
In the case of some of these brokerage and banking firms, the CEOs and COBs responsible for lack of such strategic risk management no longer hold these positions.
In these cases, the markets now seem to be discounting potential for future improvement and recovery rather than discounting future uncertainty.