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In a previous article, I explained the mechanics of the derivatives trade that cost JPMorgan (NYSE:JPM) billions. In that article I noted that it is nearly impossible to estimate what the losses on that trade will ultimately be, as it is difficult to know how much of the trade has been unwound and at what price.

A careful examination of the JPMorgan's financials in the coming quarter may shed some light on the matter, but it will take a discerning eye (or perhaps a forensic accountant) to decipher the numbers, as the truth is likely to be hidden somewhere in the "Notes To Consolidated Financial Statements". The devil will be in the details, specifically in the note which discusses "changes to Level 3 fair value measurements". If you are unfamiliar with the distinction between the three levels of fair value measurements, consider the following:

"GAAP classifies inputs to valuation models as either Level 1 inputs, Level 2 inputs, or Level 3 inputs. Level 1 inputs are those that are derived from observable market prices for the instrument in question, Level 2 inputs are those derived from the assessment of market prices for instruments comparable to the instrument being valued, and Level 3 inputs are those the firm develops based on its own models."

Clearly, Level 1 assets are the most reliable in terms of determining the financial condition of the company - they are based on actual prices for the instruments in question. Level 3 assets are primarily determined by reference to the company's own valuation models, a practice which can be inherently self serving.

As JPM's derivative bets were so large that they disrupted prices in the underlying indices, it may be difficult for it to determine prices for them based on observable market bids. This could necessitate a transfer of large chunks of assets from Level 2 (where the majority of the company's fair credit derivatives instruments are currently held), to the dubious Level 3 category, where JPM will be allowed to use its discretion in pricing the instruments- if the Bruno Iksil trade is any indication of what happens when the company uses discretion, this may not be such a good thing.

Financial companies typically report transfers of assets into or out of Level 3, so investors will at least be able to assess exactly how much of the ill-fated trade has been reassigned. What is particularly worrisome however, is that, according to The New York Times, JPM's Level 3 assets as a percentage of tangible common equity is already more than double that of both Citigroup and Bank of America (84% compared to 39 and 33% respectively). This is a problem because, as the NY Times notes, a high percentage of Level 3 assets to tangible common equity was one factor which contributed mightily to the near demise of several large firms during the financial crisis of 2008. If that ratio were to double (for JPM) this quarter, it would be higher than it was going into the first quarter of 2009.

Investors should not write this off as a non-material, obscure accounting issue - it is far from insignificant. If JPM moves a large portion of its credit derivatives to Level 3, it will be allowed to value those assets largely according to its own models. The concern is that JPM will not value the assets conservatively (indeed it may not even do so maliciously, as prices for some positions may be almost indeterminable) and will report earnings that could easily mislead the average investor who likely has no idea that losses may be (legally) hidden in the way the firm values its Level 3 'assets'. Indeed, academic research has shown that the larger the bank, the more likely the firm is to use Level 3 valuations to 'manage' earnings - JP Morgan is the largest bank in America. Short JPM.

Source: JPMorgan: Fair Use Of 'Fair Value' Will Determine Usefulness Of The Next Earnings Report