Research & Advice

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Level Three Accounting

November 6, 2007

Haven’t heard of Level Three Accounting?  By the time you do (or at least by the time you read about it in the newspaper and/or hear about it on the TV) the Financial sector of the economy and of the stock market will be going through the ringers (even more than it is now).

I am not going to get into the details of accounting because that will just bore most people.  So I apologize ahead of time to those that, like me, love the details.  But trust me there will be a lot of commentary from other news sources on this subject in months to come.

There are three pools of assets (Level 1, Level 2 and Level 3) that preparers of financial statements must classify.  The most liquid and easily identifiable assets (as far as prices and valuations are concerned) are Level 1 holdings.  These could include common stocks (IBM, GE), mutual funds, ETFs, etc.  Level 2 holdings are less frequently traded securities (like restricted stock) which may be valued by using either recently executed prices or even prices of similar, more liquid investments.

Level 3 holdings include CDOs, subprime mortgages, and other often-unpriceable holdings that require assumptions, guesses, and too-often hopes of what a price might be.     

So when you hear about a major investment bank being unsure about what future write downs may be, they are really saying that they are not sure how to value the holdings in the Level 3 asset pool.  And unless they go ahead and sell a portion of the assets in question (which gives us a real-time market value) they likely will have to assume, guess, and/or hope that that what they “calculate” at the end of the quarter will be accurate.

So how concerned am I with the hidden time bombs buried in Level 3 accounting pools?  Let’s try to make some comparisons. Admittedly, comparisons are difficult because we do not know what the Level 3 write down losses will ultimately be.  Currently most estimates start at about $100 billion, but there has also been quarter-trillion dollar figures bandied about. 

To put things in perspective, in 1998 the infamous hedge fund Long Term Capital Management imploded.  The losses were not $100 billion, but closer to $3 billion (less than what Citigroup has already written off).  And the result was about a 20% haircut on the stock market.

A better comparison might be the savings and loan crisis of the 1980s.  Over 1,000 savings and loan institutions failed and losses totaled $150 billion (that amount has not been adjusted for inflation).  It is hardly arguable that this was not a huge contributor of the 1990-1991 recession (an oil price spike and Fed inflation fighting also contributed).

On the other end of the spectrum is the three-quarter of a trillion dollars worth of losses that Japan lost its 1990s banking crisis.  That led to a decade of economic and market turmoil.

Using empirical evidence to extrapolate possibilities, this situation may be most like the 1980s savings and loan crisis.  The result?  A recession.  And what is a recession good for?  Usually about a 20% loss in the stock market.