Which I-Bank is the Most Vulnerable to Level 3 Assets?

Includes: BSC, GS, JPM, LEH, MER, MS
by: Thomas Tan, CFA

On Thursday, the new regulation FASB 157 came in force for banks, especially for investment banks with large inventories of structured products. This new account rule is basically asking banks to assign real and true values on their CDOs and SIVs.

There are 3 levels of assets according to FASB 157, with level 1 the most frequently traded and plenty of liquidity with bid and ask prices, and level 3 having almost no market and pretty much marked to computer models.

These days most of the write-downs and likely additional future write-downs are related to level 3 assets. So it makes sense to see what amount of level 3 assets each bank has. Different banking analysts have different estimates, but some of their estimates are listed in the table below.

If these estimates turn out to be close, we can compare these numbers with the equity of these banks. I can get their equity numbers easily enough from their balance sheets at Yahoo Finance. As a result, we can see GS and MS actually have the largest percentage of level 3 assets compared to their smaller equity base due to the nature of investment banking business. However, both of them have performed some kind of hedging by shorting the ABX index. It seems that GS is fully hedged, so they don't expect any write-down. MS has hedged too, but based on an article in the WSJ last week, the hedge is not working as planned - a short has somehow turned into a long, resulting a $3.7M write-down.

So I created a new ratio, similar to return (earning) on equity [ROE]. I call it WOE (write-down on equity), a measure of loss compared to equity. So far, ML has won the race, resulting 21% of WOE. I expect more write-downs for Merrill (ML), Citi (NYSE:C) and Bear (NYSE:BSC). However, C has a large equity basis, diversified business and global reach, will likely survive. ML could eventually get 1/3 of their equity wiped out by possibly forgetting to hedge, but will likely survive too due to their lower margin but strong brokerage business.

The most dangerous one is BSC, with the smallest equity base. If not properly hedged, in case of level 3 assets losing half of their value (a likely scenario with no hedge), their equity could be pretty much wiped out.

So far Lehman (LEH) and JP Morgan (NYSE:JPM) sound fully hedged and don't expect significant write-downs. Another bank not on this list is Barclay's (NYSE:BCS) - they just announced $2.7B write-down. Also as a power house on quantitative trading, it is suspected that they probably suffered some losses back in August as well, when most quant funds had very difficult time.

IB Equity Level 3 % of Level 3 Write-down WOE
LEH 18 22 122% - -
BSC 12 20 167% 1.2 10%
JPM 110 60 55% - -
GS 35 72 206% - -
MS 35 90 257% 3.7 11%
C 120 125 104% 11 9%
ML 39 15 38% 8 21%

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